The Future of Regulation

Time to return to fundamentals                                                                                                                       PDF Version

Within any market driven capitalist system there are certain institutions that cannot be allowed to fail if we are to avoid complete systemic collapse. This has been vividly illustrated over the past year by Governments around the world stepping in to support a banking sector on the very brink of such a collapse.

These institutions therefore occupy an incredibly privileged position where their commercial liabilities are effectively underwritten by the taxpayer. No other corporate entities, regardless of the size or scale, enjoy a similar level of protection against the vagaries of corporate trading.

With privilege comes responsibility, particularly for the Boards of Directors of the institutions in question. As we have seen by the events of the last twelve months, the manner in which those responsibilities have been discharged leaves a lot to be desired.

The natural political reaction is that what has happened has been a gross failure of regulation and that the remedy is more and better regulation. Here I am indebted to the Times Economics Editor – Anatole Kaletsky. In his commentary in the Times on 15 June 2009 he wrote:

‘Perhaps the clearest lesson of the crisis, if only policymakers are willing to accept it, is that regulation needs to better targeted and more intelligent, rather than more extensive. Rather than extending their reach into areas such as hedge funds, which had nothing to do with the financial crisis, regulators must make sure that systemically important banks have enough capital and risk free government bonds or central bank reserves to cope with liquidity withdrawals. Equally regulators must avert any repetition of fiascos such as mark-to-market accounting, risk-based capital requirements and reliance on private credit rating agency models. All of these errors reflected the market-fundamentalist ideology that the markets are always right.

If markets were always right, there would be no need for regulation and there would never be any financial crises. The reality is that markets are usually right, but are sometimes disastrously wrong. The challenge for governments and central bankers is to judge when markets should be left alone and when they require intelligent and focused regulation. A good way to start would be to look more objectively at the mistakes of the past 12 months.’

I concur with that analysis, so in an attempt to take the debate forward let me summarise what I believe to be the key issues that lead to the credit crisis:

  1. That in moving into the sub prime mortgage market several leading financial institutions, on both sides of the Atlantic, abandoned what were accepted standards of prudent and diligent lending.
  2. All too often this sub prime issue is described as a predominantly US phenomenon but it is now clear that a significant number of European Banks were adopting an equally irresponsible lending policy. The classic models of borrowing short and lending long on unsustainable income multiples were eagerly embraced by a number of UK financial institutions that are now in intensive care with the taxpayer providing life support.
  3. The securitisation of the mortgage debt was in part logical, and could, if the underlying lending had been sound, have helped to defray risk. As it was, the main consequence of securitisation was to render the resulting instruments remote from the original lending with the result that the newly created derivatives acquired a quality rating that belied their heritage.
  4. In this, the role of the credit rating agencies has to be questioned. How was it that huge volumes of mortgage backed securities and derivatives acquired a triple A rating when any realistic assessment of the underlying lending would have raised significant questions as to the validity of that rating?
  5. Apart from those institutions that were active in creating the sub prime market, there were even more that actively sought investment in the securitised instruments. Was that investment decision based purely on the market rating? If not what other due diligence did these institutions undertake before putting their capital at risk?
  6. When signing off their participation in sometimes complex derivative instruments, did the lead executives of the institutions in question really understand the instruments they were dealing with? To what extent were they qualified to understand the complex algorithms that are part and parcel of the derivatives structure?
  7. It is now 14 years since the Barings collapse when the bank suffered crippling losses through the SIMEX trading of Nick Leeson. It seems that one of the key reasons that the accumulating losses were not identified earlier (in time to save the bank) was the apparent lack of understanding of both the market and its instruments by Barings’ senior management. Had they understood the workings of the market, the constant requests from Leeson for more cash to cover daily option margins would have rung very large alarm bells.
  8. To the same extent, if the senior management of the worlds largest financial institutions had really understood the genesis of these mortgage backed derivatives would they have stepped back and requested further due diligence before putting their shareholders’ capital at risk? Would they have placed so much reliance on external credit rating agencies?
  9. The mass popularity of the mortgage backed securities market has been compared to the comfort effect of swimmers in shark infested waters. The presence of so many swimmers all enjoying themselves can only mean I am missing out. This was particularly the case with some European institutions who entered the market late, with huge enthusiasm, only to become some of the most prominent casualties in the collapse.

Anatole Kaletsky’s counsel that ‘regulation needs to better targeted and more intelligent, rather than more extensive’ is, in my view, spot on. There is a long history of regulators, both in Europe and the USA, providing some form of knee jerk reaction to the latest crisis and what then emerges is a new set of convoluted regulations that become a burden to both the industry and the consumer whilst not adding any real advance in terms of diminution of investor risk.

If regulators seek to put process controls around every aspect of a market thereby requiring hours of box ticking and mindless compliance they will achieve no more than increase the risk of the same thing happening again. This type of compliance process becomes routine and a function of box ticking rather than of considered and careful thought.

I believe we need a return to the fundamentals such that a Board of Directors takes real and substantive responsibility for the management of the financial institution they govern. In this scenario, they would not invest in any securitised market unless they had a thorough understanding of the market and the structure of the securities they would acquire. It is now self evident that the majority of the directors of the institutions that have been crippled by the events of the last eighteen months had no real understanding of the securities and derivatives they were buying. If they had, then why didn’t they stop it?

In this context, we also need a considered review of the way critical investment decisions are made and the basis under which individual directors sign off on the board decision. In my view, it is palpably inadequate for a director to place complete reliance on an outside credit rating agency for an investment decision. Equally, we need to consider the degree of reliance an individual director can place on internal management assurances that a particular derivative is effective and will prove a good investment.

Take for example a major investment proposal based on a derivative contract. The derivative contains a series of complex algorithms’ that only one applied maths graduate amongst the bank’s staff really understands. The directors are not qualified to know whether the algorithms produce the effect they have been advised and they are intellectually incapable of testing the competence of the applied maths graduate. In those circumstances should they invest and, if they do, have they done enough to fulfil their fiduciary duty of care?

The short answer must be no. The risk of substantive financial loss increases exponentially in any situation where the Board of Directors of an institution do not really understand the investments they are making or the derivative risk they are covering. We all accept that the modern world becomes more complex every day but that does not mean that we can import risk into our key financial institutions where the directors charged with its management do not fully understand how the instruments work.

In summary, I would propose three measures that would require little, if any, new regulation but would I believe go to the heart of the issue:

1. Personal Liability for Bank Directors

Every director of key financial institutions should be required to sign off on the company’s accounts and specifically confirm that he/she understands the Balance Sheet and considers that the assets and liabilities are fairly stated. The director would be personally liable for this statement and would face severe sanction in the event that he/she was shown to have signed the statement with inadequate background diligence.

2. Banking Regulation – both Capital Adequacy and Director Competence

The UK and US governments have already taken action with regard to capital adequacy and the imposition of more robust stress testing for all banks. That should, in my view, be extended such that the banking industry regulators are required to assess the competency and experience of the Board of Directors and, if found wanting, the regulators should have the authority to demand change.

3. External Audit

The external audit remit should be extended to include a review of investment and lending policy and practice within the bank. Particular attention would be given to the making of investment and lending decisions, the quality of the related diligence and the competence of the individual directors to make those decisions. Quite simply do they have the knowledge and experience necessary to make an informed decision? Where the Board lacked that collective knowledge, what action did they take to obtain competent advice before the decision was made?

I can quite imagine that some of the major banks would view the above proposals as invasive and an inappropriate interference to the Board’s shareholder mandate to manage the bank. I would agree that external checks on director and Board competence are invasive and that it is the intent.

The banks must realise that their collective failure has rendered enormous damage on the world economy and that thousands now face the prospect of unemployment as a direct result of their incompetence. Some of their investment decisions during the heat of the bull market now seem little more considered than bets at a casino. Rushing into major derivative investments without a real understanding of the market or the instruments they were buying with their only apparent defence being that the external agencies rated them triple A.

During this period of herd instinct investment decisions, the boards of the major banks were full of experienced professionals holding both executive and non-executive mandates. Their collective failure to challenge what was happening or seek to really understand the derivative markets in which they were investing vast sums is the most damning indictment of their performance.

All too often, in the past, Non-Exec Director Appointments have been made on some form of ‘old palls club’ without any real diligence on the key question of whether the appointee has the knowledge or intellect to really understand the business of the bank. Clearly this must change.

As the regulators address this issue, I would hope that they will recognise the core issue and not be tempted down a path of broadly based new compliance procedures and endless box ticking. The issues to be addressed are, in my view, predominantly around the competence of the Board of Directors to effectively and prudently manage the bank. If that core issue is not addressed, no amount of peripheral regulation will stop this happening again. 

16 June 2009

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