Shares digital

There’s a cycle of risk and regulation, and right now the regulatory hawks are in the driving seat

by Stephen Barber

The market uncertainty from the sub-prime fall-out has left investors jittery. But if there’s one certainty to emerge from the recent banking crisis it is that financial institutions on both sides of the Atlantic will face tougher regulation in the months to follow. Rightly too, most people would agree, even if some of the problems might have been avoided had regulators been more attentive. This latter point is certainly the view of the Financial Services Authority’s internal audit, which identified four major failures by the organisation to regulate the ill-fated Northern Rock. This included ‘a failure to ensure that all available risk information was properly analysed and applied’. In the end, did it really matter? The UK government was willing to intervene to nationalise the ailing bank just as the US administration stepped in to alleviate the (far more serious) situation with Bear Stearns. It demonstrates that we exist within a regulatory cycle.

The issues raised with this crisis are not only far-reaching but also more subtle than headlines might suggest. Take the idea of ‘moral hazards’, that is the concept (first identified by the French economist Jaques Drèze in 1961) that we all quite naturally adjust our risk-taking to the environment in which we find ourselves. While generally a responsible driver, I am still more careful to drive within the speed limit when there are cameras around than on an empty country lane, and my posture is akin to that on the day I took my test when I saw a police car. Likewise, investors understand the nature of market risk and its commensurate rewards, as do the banks and other financial institutions.

Risk is not, in itself, a bad thing so long as it is understood and accepted by those involved. Moral hazards muddy the waters somewhat. They allow for transference of risk, insurance if you like, which in economics can mean a safety net provided by government, at no cost to business, for the greater good of confidence in the system.

Returning to the driving analogy, I once had a friend who worked for an embassy in London and who was fortunate enough to sport diplomatic number plates on his rather shabby car. This ‘moral hazard’ meant that he had few reservations about speeding, cameras or not. If readers of these pages knew that their losses would be written off by Shares magazine for the good of investors generally, they would take greater risks.

The same is true of the financial services industry. Each time government bails out an ailing financial institution there is a sense of annoyance that a failing business should pay for its own mistakes and that the taxpayer should not be expected to pick up the bill. There are of course greater considerations than simply saving the skins of wealthy bankers who should have known better. Governments rescue the likes of Northern Rock and Stearns – they indulge these moral hazards – to prevent contagion, to maintain liquidity and to restore confidence. Moral hazards might be unattractive, but they are also unavoidable in a stable economy.

A regulatory season

The 2008 banking crisis isn’t the first occasion we have seen these moral hazards at work and it won’t be the last. The pattern is always the same, as readers with longer memories will recall. Back in the early 1980s the US Congress deregulated the savings and loan associations but maintained state administered deposit insurance. Bank executives were able to take huge, irresponsible risks safe in the knowledge that the government would come to the rescue. The consequence of the banks’ recklessness was inevitable: The Financial Institutions Reform, Recovery and Enforcement Act was passed in 1989 to restructure the savings and loan industry and its regulation. Whenever such regulation is introduced, it affects not only the minority of badly run institutions, but all; it not only seeks to deal with market failure but attempts to influence management direction.

Here’s the natural cycle that forms part of our economic life: we start with the premise of loose regulatory controls and throw into the mix the sort of moral hazards discussed. The result is a combination of higher profits and temerarious behaviour performed perhaps by only the few. In turn there is crisis and reduced public confidence in the sector. Government steps in, increasing regulation, and there is restored confidence. In turn this leads to reduced risk-taking but also reduced profits, which eventually increases pressure for the inevitable de-regulation. We are back to the beginning of the cycle.

Clamour for control

Why, though, given that the vast majority of banks and other financial institutions behave well, will there be such a clamour for greater regulatory control this time, just as we have experienced historically? The answer lies in the political as well as the economic nature of the cycle. Our system does not accept the ‘few bad apples’ thesis because there will be public demand for the sort of action witnessed in the wake of the Enron-led corporate scandals of a few years ago. Sarbanes Oxley, was a hurried piece of US legislation which, some argue, was detrimental to many firms’ economic wellbeing, but it served their political standing well. After all, politicians enact these regulations to assuage the electorate and (usually successfully) restore public confidence. And restored confidence is exactly what the banking sector, in Europe and in the US, needs now more than ever.

Stephen Barber is head of research at Selftrade (www.selftrade.co.uk)