What are the Academic arguments for and against public body regulation

What are the Academic arguments for and against public body regulation?

For:

The main argument for public body regulation is to prevent the threat of systemic risk. By this I mean the fact that if one bank went bankrupt that this would have a knock on effect on the others and that they too might fall into trouble and hence go bankrupt themselves. This would have a detrimental effect on any economy and in most cases it would be too big of a blow for any economy to recover from. (Japan being the obvious example).

Another argument is to prevent the so called “Disaster Myopia”. This is simply the tendency of banks to underestimate the probability of low frequency shocks. The problem is also added to by the fact of “herding”. E.g. In most cases it is impossible to put a financial figure on risk so normally the Banks tend to stay at around the same one. This gives them the reinsurance because they are part of a group so individually they cannot be wrong and they know that if they fall into trouble then as all of the banks are in the same boat with them it is very unlikely that the government will not help them.

Another argument for public body regulation is to bring in an outsider who doesn’t have a personal interest in any way. So to explain this a little better I will use an example: A manager whose pay is profit related is not going to allow huge provisions be made in the P&L because naturally they will reduce his profit and thus his pay. In a lot of cases his bonus is related not only directly to the banks profits but also their stock price so it would be in his best interest to keep profits as high as possible. If an outsider was overseeing this in some way then as they would not have a personal interest in the banks profitability then they could make an unbiased call on the required provisions.

This was evident in the savings and Loans crisis if the US, where these S&L’s made their profit simply by giving out long term fixed rate mortgages and taking in short term depositors. For years this proved very profitable until interest rates increased beginning in 1966 and thus the S&P’s were left with a mismatch. i.e. instead of earning money they were now losing it. Instead of increasing their reserves the managers simply ignored it and did not adjust for it in the P&L or Balance Sheet. Why? Because they wanted to sustain their profits in order to keep their bonuses. If someone independent was around then they might have reduced the S&P’s exposure to interest rates and increased their reserves and provision and thus avoiding the crisis.

I feel that public body regulation needs to be in place to protect medium sized banks. The big banks know themselves that the government is not going to leave them go bankrupt if they fall into trouble (AIB in 1990) and the smaller banks themselves know this as well. So naturally the tendency is there for the smaller banks to try to expand their capital base to push themselves up to the status of a “big bank” and thus they know they are protected. However this of course leaves them at risk of overstretching and leaving themselves vulnerable. This ...

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I feel that public body regulation needs to be in place to protect medium sized banks. The big banks know themselves that the government is not going to leave them go bankrupt if they fall into trouble (AIB in 1990) and the smaller banks themselves know this as well. So naturally the tendency is there for the smaller banks to try to expand their capital base to push themselves up to the status of a “big bank” and thus they know they are protected. However this of course leaves them at risk of overstretching and leaving themselves vulnerable. This is where they would need to be regulated, to protect themselves. Of course big banks need to be regulated as well, but that goes without saying.

Against:

The main argument against public regulation is that if it was not in place banks would be able to self-regulate more efficiently. They would see that the “safety net” the government provides is no longer there so they would have to in order to stay in business. The investors would know that their money was not “risk free” so therefore would put pressure on the banks to regulate themselves to protect their money.

It is not public body regulation that is needed but internal control. Neither the John Runsack nor Nike Leeson cases would have spiralled so out of control if the banks had proper internal control in place. I do not believe that public body regulation would/did have any impact on these cases happening.

Banks need to change from within first. No regulation will work if it is forced on them. Like anything one needs to want/have the will to change before they actually do. You cannot force the banks to change unless they want to.

How does the analysis of recent banking disasters inform the debate?

In 1995 Nick Leeson, the original rouge trader, famously sent Barings “The Queens Bank” bust after incurring over $1.3 billion dollars of trading losses since 1992. The final straw came when Leeson, getting desperate to make up for his losses, bet that the Nikkei index would not drop below 19,000 points. At the time this seemed reasonable as the Japanese economy was rebounding after a 30-month recession however, on the 17th January 1995, a devastating earthquake measuring 7.2 hit the Japanese city of Kobe. Leeson, then bet on a post earthquake recovery and bet that the market would stabilize again at 19000 points. It never happened. In this period (post earthquake) he accumulated some three quarters of the $1.3 billion loss.

In February 2002, AIB share price plummeted 17% on the news that a rouge trader by the name of John Rusnak had run up losses of $691 betting on the foreign exchange market in their Baltimore based subsidiary Allfirst.

I believe that the analysis of recent banking disasters shows that first of all banks do not self-regulate properly. The losses sustained in these two cases could have been minimised if proper internal control had been in place. In his autobiography Leeson states:

“The old school really never understood or cared to master the complexities of derivatives trading”.

So if his supervisors didn’t understand what he was doing how were they expected to keep check on him? However having seen what happened to Barings this brought the issue of internal control to the forefront for the banks themselves. Yet only a few short years after it the Allfirst scandal came about. I believe that this shows that cases such as rouge traders are almost impossible to eliminate, what is important is the damage limitation. E.g. the initial loss is very hard to stop, it is the subsequent losses that follow it due to poor internal control is the issue that needs to be addressed.

e.g. the first entry into Leesons 88888 error account was $20000, a mistake that an employee of his made that Leeson covered up as he was embarrassed of it.

Also on the same point I feel that public body regulation is useless in trying to stop something such as a rouge trader happening. Where it needs to focus on is to ensure that banks are equipped to take such a hit if needed. i.e. ensuring that they have adequate reserves in place etc…

It shows that the size of the bank also matters. AIB were big enough to take the hit whereas Bearings unfortunately were not. It backs up my point that smaller banks need to be regulated more carefully because not only of the reason I mentioned above but also because of the fact that smaller a smaller bank has less of a chance of sustaining the loss than a bigger bank.

What alternatives to public body regulation do academic commentators suggest?

Richard Herrings view is that it is the safety net of the banks knowing that the government will not let them go bankrupt is part of the problem. He believes that this entices directors to take “excessive risk” as they know the government will bail them out. He believes that banks should be allowed greater diversity and that banks and other institutions should be not allowed to operate without risking large amounts of shareholder funds. In other words, his view is that the “safety net” should be taken away from the banks and that then the banks would self-regulate.

Randall S. Kroszner in his paper of March 1999 claims that:

“The lessons of the developments in the derivatives markets suggest that competitive forces have and can control risk in ways that can address public regulators’ concerns about safety and soundness of the payments and clearing system.”

i.e. He too is in favour of self regulation.

So we can see that the alternatives that some suggest are self-regulation. The reasons being that first of all that banks will regulate properly as they will want to protect their name. They will have a commercial interest to do this. Academics also suggest that the government should take the “safety net” away from the banks i.e. if they fall into trouble leave them. Their depositors will place increased pressure on them to put adequate internal control procedures in place as they know that their money is no longer risk free so thus the banks will provide better internal controls. The final argument for this is that Banks know the system better than anyone. Every bank is different in its structure, capital base, customer base, diversity etc...so no one regulation can cover every bank. It simply would not be efficient. The banks would be far more successful in setting their own guidelines and providing their own internal control. However, as plausible as these arguments sound I do not believe that in reality they would stand up as in the first case there is no way that the government would leave a big bank go bankrupt and in the second case the banks main responsibility is to their shareholders so profits will always remain their main objective, not internal control.

In your view does the threat of systemic risk in the industry warrant the current level of regulatory oversight?

In a word, yes. Although I do realise that the issue at fault was poor internal control and not a lack of regulatory oversight which caused such crises as Allfirst and Bearings, and they were non systemic i.e. did not affect any other bank. I do feel that the treat of systemic risk alone is enough to warrant the current level of regulatory oversight. It is almost impossible to think of the consequences of a systemic banking crisis say, in Ireland. The whole economy would collapse. At current banks are financial intermediates, they bring people with needs and wants together and simply create a profit for themselves in the process. E.g. They find people who want to invest money, give them a satisfactory rate of return and then find people who want to borrow money and lend that money to them (at a higher rate). The economy could not function without them.

Looking at a wider picture, if a fully blown systemic banking crisis hit then you would be more or less setting a country back 100 years. The economy would become stagnant, property markets would collapse, the stock market would collapse, people left penniless etc… Cases such as the Savings and Loan crisis in the US and the Scandinavian crisis serve to show us the danger that systemic risk can cause to an economy.

Can the Financial Markets Privately Regulate Risk?

The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations

Randall S. Kroszner