Boomtime politicians will not rein in the bankers

By Avinash Persaud**
Published: November 26 2009 (Financial Times)

One of the features that singles out the Warwick Commission on International Financial Reform, which publishes its final report on Friday, is that while other expert groups tiptoe around it, we have been able to point to the true source of the worst financial crisis since the 1930s: regulatory capture and boomtime politics.

Today regulators are working conscientiously to address the issue of banks being too big to fail; the lack of responsibility that can follow securitisation; imperfections in credit ratings; capital requirements which accentuate boom and bust; regulators which were global champions for their local banks; and more. But we should not forget that just a few years ago, regulators, with few exceptions, wanted big banks to have lower capital requirements if they had sophisticated risk models; they were cheerleaders for securitisation and asset sales by banks because, they said, this spread risks; they hard-wired credit ratings into bank risk assessment; they promoted home country regulation over host country control; and they dismissed the idea that regulation was dangerously pro-cyclical.

These and other regulatory mistakes all pushed financial institutions in the same direction. Large international banks compete better on “process” and “models” than credit assessment, and reap economies of scale when rules that segment finance within and between countries are liberalised. As I wrote here in 2002, financial regulation had all the hallmarks of being captured by banks, to the detriment of financial stability.

Separate but related to regulatory capture is the politics of booms. A boom persists because no one wants to stop it. The government of the day wants it to last until the next election. The early phase of a boom brings extra growth, low inflation and falling defaults. Governments tout this as a sign of their superior performance. Bankers argue such alchemy justifies their golden handshakes and excuses their golden handcuffs. Booms spread cheer by providing finance to the previously unbanked. Donations to worthy causes and universities temper traditional channels of criticism. How easily can the underpaid regulator stick his hand up and say it is all an unsustainable boom?

The capture and influence is subtle and there is always a genuine reason, if a wrong one, for why it is different this time. Indeed, one of the key challenges not yet seriously addressed is why the universities and press, falling over themselves to kick bankers today, did not play a more effective counterveiling force to this capture.

One indirect consequence of capture is the mistaken treatment of risk that lies at the heart of regulation. Many politicians and watchdogs think of risk as a single fixed thing inherent in instruments. As a result they put faith in processes that link capital to measures of risk, or in committees charged with determining what is safe and what is risky and banning the risky. But risk is a chameleon: it changes depending on who is holding it. Declaring something safe can make it risky and vice versa. Investment scams are attracted to booms, but booms are in fact built on the belief that some new thing has increased the return or reduced the risk of the world: motor cars, railroads, electricity, the internet or financial innovation. There is often a large element of truth about the original proposition – the world will be different – but the over-investment creates new risks.

In a world in which risk is poorly measured and regulators are vulnerable to political influence, we cannot rely as a defence against a crisis on the regulation of financial instruments, statistical measures of risk, systemic risk committees or the foreign “home country” regulator.

It is not financial instruments but behaviour we need to change. A better defence will come from increasing capital buffers at financial institutions, making these buffers counter-cyclical, and focusing on structural – not statistical – measures of risk capacity. Liquidity risk is best held by institutions that do not require liquidity, such as pension funds, life insurers or private equity. Credit risk is best held by institutions that have plenty of credit risks to diversify, such as banks and hedge funds. No amount of extra capital will save a system that, because measured risks in a boom are low, sends risk where there is no capacity for it.

**The writer is chair of the Warwick Commission, chairman of Intelligence Capital and an emeritus professor of Gresham College