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Success of fiscal control depends on who holds the whip

Analysts believe that simply strengthening the rules is pointless if the people supposed to be enforcing the rules fail to do so

Gulf News

Dubai : More than three years after severe economic shocks brought the global banking system to its knees, regulators, economists and analysts are still divided on the steps nations need to take to protect banks and credit markets from another implosion.

The world is looking to the United States to come up with a workable plan to regulate the financial markets. But, the country that witnessed the largest number of bank failures during the meltdown is still groping for a solution that holds guarantees for the future.

"The answer is not just to hire additional regulators and pay them more. The model of supervision must be rethought fundamentally," Patrick Butler, a director with McKinsey & Co, wrote recently in a note.

Early this year, the Obama administration indicated its support for Paul Volker's solution. Volcker, who now heads the President's Economic Recovery Advisory Board, is a former chairman of the Federal Reserve. He proposed what is now being called the "Volcker Rule", that "banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers." The separation of retail and investment banking — which is what Volcker is essentially proposing — has been the holy grail of banking regulation for the longest time.

Fine line

Emerging in little wisps out of the murky environment is the view that there is a fine line between strengthening regulation and appointing better regulators. Analysts believe that simply strengthening the rules is pointless if the people enforcing the rules fail to do so.

"It's very hard to figure out what the Obama administration's plan for regulation is. Congress has taken the lead. The congressional lead appears to be through higher levels of capital requirements. What the Obama administration wants to do in following the Volcker plan is to limit the trading activities of the commercial banks. That's sort of intriguing," Robert Z. Aliber, a former professor at the University of Chicago Booth School of Business, told Gulf News.

"The banks did not get into trouble because they were involved in esoteric financial instruments. They got into trouble because they made bad judgements about the credit risks involved in the housing market. So it was traditional banking, not financial engineering, that was the cause," Aliber said.

Aliber, who has consulted for the Federal Reserve, the World Bank and the International Monetary Fund, was in Dubai as part of the Middle East Speaker Series hosted by Credit Suisse. He is also author of several books, including Manias, Panics, and Crashes: A History of Financial Crises.

"I think one could say that central banks were not on the ball in analysing what was happening in the credit markets, what was happening in the housing markets. Before we have new regulation, we might ask the question: why is it that regulators failed to prevent most crises?" Aliber said.

"The climb in house prices in the US began at some point in 2005. The financial problems began at the end of 2006. What were they looking at for two years? Where were the regulators?"

Aliber is scathing on the quality of regulators: "Even if the regulators had all the information, the money of the regulators is not on the line. I think it's a fair statement that the quality of the regulators is not quite at the same level as the quality of the bankers."

Butler suggests that one possibility for regulators could be moving to enforcement based on rules rather than the prevailing "guidelines" approach. "[The rules] could include imposing tighter supervision, restricting dividends or bonus payments, or requiring debt-to-equity conversions until proper ratios were restored," he said.

However, Aliber views that as "too mechanical". Suggesting that regulation takes a more macro-economic perspective, he said: "I'd like to look at the imbalances in the economy during a bubble period." He suggests institutions most at risk can be identified as the ones that grew much more rapidly than the average. A better indicator of a bank's possible failure would come from the true value of its assets, and whether these values are likely to be sustained when the expansion is over.

Red flags to watch

Tracking the true long-term viability of the assets owned by banks is not a problem faced only by developed nations. Frontier economies — such as those of the Arabian Gulf — have as much stake in keeping a keen eye on the asset side of the banking balance sheet. Robert Z. Aliber, a former adviser to the International Monetary Fund, believes that during a period of rapid real estate expansion, the question that should have been asked is: what was the source of the financing? "Was the expansion of real estate inside the banks or outside the banks? And even if the major source of the financing of real estate was outside the banks, the banks hold such large proportion of real estate paper, that the real estate values can have an adverse impact on their capital."

— Y.D.