Banking firemen won’t stop spotfires

As global regulators obsess over banking stability, their focus is effectively corrupting their ability to spot the next crisis.

Nearly four years after the Wall Street bailout, the beneficiaries of the US government’s support are battered and unpopular, but still in business. Meanwhile, the regulators that rescued them are in trouble.

The Libor affair is the latest scandal to affect the already low reputation of the big banks. It adds to most taxpayers’ feeling that they were forced to support a set of institutions that did not deserve it. "They should be enraged by the broken promises to Main Street and the unending protection of Wall Street,” writes Neil Barofsky, the former special inspector general of the troubled asset relief programme.

Barofsky’s book Bailout renews his lengthy grudge match with Tim Geithner, the US Treasury secretary, whom he saw as over-sympathetic to Wall Street. "I find that deeply offensive,” Geithner complained haughtily to Charlie Rose of PBS this week when faced by the notion that, as former president of the New York Federal Reserve, he was too close to the industry.

Geithner protests too much. His own description of the New York Fed – "the fire station of the financial system” – encapsulates the difficulty. Since 2008 (and before), regulators have faced conflicts between their dual mandates of disciplining banks and keeping the financial system running. Their immediate priority is to put out the fire, not to catch and punish the arsonists.

His mantra in the 2008 financial crisis was "first, do no harm” – keep Wall Street and small banks solvent before turning to the question of regulating and controlling them more effectively. The combination of the European financial crisis and the Libor scandal threatens a similar pile-up of principles.

The Libor abuse, shocking even to those who have followed the banking industry for years, could easily culminate in criminal prosecutions of the traders involved – and even a US indictment of a European bank. That would be carried out by the US Department of Justice, with the Fed fretting on the sidelines.

The Fed is already worried by the effect on financial stability of severe disruption at institutions that are integral to US markets – Barclays, for example, is a large trader in US Treasury bonds. If a big European bank failed, it would cause chaos at US money market funds and ripple through the system.

One doesn’t have to believe Barofsky’s view that the relationship between the Fed, the Treasury - and central banks and regulators elsewhere - and the financial industry is inherently corrupt to identify a problem. Any oversight that is biased towards preserving stability will often shy from making life too difficult for banks.

In theory, there is no conflict between the two: it is just a matter of timing. While a regulator has to go soft on banks during financial crises for fear of making things worse, it can - and should - get tough before and after the crisis.

In practice, the latter has not impressed. This crisis never quite goes away, moving seamlessly from US mortgages to the slow-motion break-up of the euro. The big banks remain too big to fail - even Sandy Weill, architect of the dismantling of the Glass-Steagall Act at Citigroup, called yesterday on CNBC for its reinstatement – and the financial system remains fragile.

The only way to curb the conflict in the long term would be for bank supervisors to prevent banks from taking excessive risks and adopting inadequate business models, such as Northern Rock’s heavy over-reliance on impermanent wholesale funding. They could then crack down on banks’ practices before the next crisis made it awkward.

Most supervisors admit that they were too lax in the past, taking an efficient markets view of banking - their job was to identify risks, and bring them to the attention of bank executives, but not to tell them what to do. "You can’t keep on analysing risks,” says one European supervisor. "You have to take action.”

Apart from a general reluctance on the part of modestly paid and under-resourced supervisors to battle with wealthy, assertive bankers, they were held back by a philosophy that trading was a professionals’ market in which everyone knew how to take care of themselves. Various scandals have disproved that.

As Adair Turner, chairman of the UK Financial Services Authority, said this week, it is possible for a banker "to make huge amounts of money out of a multi-step chain which connects ill-informed investors in one country to ill-informed subprime borrowers in another, and still go home believing [he is] a fine upstanding member of society”.

A good point, but how much faith can we have that supervisors will be noticeably more effective? I am sceptical, not because they will not try, but because it is a difficult job and history is against them. Although 2007-08 was an extreme episode, regulators have never prevented periodic banking crises.

"The reality is that regulators are all over the banks at the moment, as you’d expect,” says one executive. "But neither bank CEOs nor supervisors have ever been good at catching the next problem.”

Some regulators talk of altering their own incentives – imposing rules and triggers that would stop them fussing around too long when they are worried and instead spring into action. But they will always be heavily outnumbered – the Fed has only about 50 on-site examiners at a bank that employs more than 100,000 people and manages trillions in assets.

While supervisors grapple with big, complex institutions filled with bankers who are encouraged not only to take unwise risks but also to break the basic rules of conduct, they will struggle. Every so often, the priority of institutions such as the Fed will be to extinguish fires that were preventable.

Were it as simple as removing Geithner from his post and appointing someone to Barofsky’s taste, then life would be simpler. The unpalatable truth is that he was doing a large part of his job.

Copyright The Financial Times Limited 2012.

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