Change for the Sake of Change?

Throughout the last four weeks we have a gone through somewhat of a journey first discussing how the FSA catastrophically failed to do their job, then we talked about how this called for a change in financial regulation through the use of the central bank in financial regulation and in the last post we identified the new proposed structure of financial regulation in the UK. This has all lead up to the point where the question has to be asked will these changes make a difference.

If we were to adopt a free banking way of thinking then the answer would be clearly not as they believe against banking regulation of any form. However for those of us who do believe in banking regulation (the vast majority), it would be of interesting to look at the following diagram:

Although from the USA this tells its own story, once tighter financial regulation was put in place after the great depression the US enjoyed a period of around 40 years with low levels of bank failures and if we look at the red line it also increased equality. So if the UK gets its “house in order” in terms of financial regulation there is a real opportunity to bring back stability into the UK banking sector.

Some argue that the structure was not what wrong in the first place but the people within the structure were the problem and a lot of these same individuals will be involved under this new structure. So is it a case of same organisation with the same mentality but different names (such as PRA and FCA) within the UK regulation. This is clearly something that will have to be avoided. Also there is a question of the transition period to this new structure which some critics argue could take up to two years and this is plenty of time for the FSA to “take its eye off the ball”.

Have I been naïve up until this point? To a certain extent yes, to put the last financial crisis down to the FSA and think that the change in financial regulation by its self can be the cure to a problem that goes much deeper. So to say financial regulation would be the sole contributor and the future saviour of financial crisis to come would be incorrect, but its importance cannot be underestimated within the wider context of future stability, its role is unquestionable.

A View From the Top

As was highlighted in my previous post there is a need for a subsidiary within the Bank of England to prevent against possible conflicts with the monetary policy committee. This subsidiary will take the form of the Financial Policy committee. According to Mr. Sants “unencumbered by the FSA’s old “light-touch” approach, these watchdogs are ready for the tough, “proactive” and “judgment-led” philosophy that the coalition government is trying to foster”.  This new structure is illustrated by the diagram below (source, HM A new approach to financial regulation); 

As you can see from this diagram at the top is the FPC and from this organisation there is going to be two new financial regulators, the PRA and the FCA. Beginning with the prudential regulation authority (PRA), they will be in charge of regulating, insurers. According to the report “PRA supervisors will focus on developing a clear understanding of the financial soundness of firms and risks to their business models.” 

Then the second organisation will be The Financial conduct authority (FCA) and they will be in charge of the “good conduct” of business as the government sees this as an “essential element of a strong and efficient financial system”. At the head of these two organisations will be the financial policy committee whose overall objective will be to “protect and enhance financial stability” and it will hopefully achieve this objective through the use of the PRA and the FCA. The main functions of the FPC will be to “monitor the stability and resilience of the UK financial system with a view to identifying and assessing systemic risks and; use the levers and tools at its disposal to address those risks.” (A new approach to financial regulation 2010).

So it is clear with this new structure and the new objectives of these organisations that the Government have learnt from the lessons of the past as highlighted by my first post “The FSA; where it all went wrong”.  I feel it is appropriate to finish off with the words from the great Winston Churchill “all men make mistakes but only wise men learn from their mistakes”    

Back to Square One

This change I spoke of in my last post will be in the form of the Bank of England being in control of financial regulation (back to the way it used to be). If we look back to the characteristics of a central bank we do indeed see that banking regulation is one the characteristics of a central bank. This means that the role of the bank of England will be extended to include “stopping systemic risks and stopping danger in its tracks” (citywire.co.uk). This will be carried out in a “twin peaks” format which will be discussed in next week’s blog. The purpose of this blog is to discuss the reasoning why a central bank should be (or shouldn't be) involved in regulating banks.

 

The link posted below is a debate between former members of the Bank of England and MPC talking about the role of central bank as a regulator (those in the debate are, Charles Goodhart, Sir John Gieve and Paul Mortimer-Lee):

http://www.centralbanking.com/central-banking/news/1731741/central-banks-preferred-regulators-centralbankingcom-panel

One of the key points from this extremely interesting debate was that with the central bank being involved in financial regulation is that it can be “the boss”, which is very helpful so one objective rather than what happened before where three separate objectives, which gives rise to a "them and us mentality".

Another point highlighted is that the economy is not constructed in “a block recursive manor” meaning that in the “real world” there isn’t a separation, so there is greater logic to have macro prudential policy with monetary policy but they do raise the question, does this only need to happen in a crisis? However they do point out this can only work in certain countries, it can’t work in Europe. They do acknowledge it would be easier if across the world all central banks were in control of regulation. This would make it easier to cooperate and harmonise the global financial regulation because of the central bank’s “traditions, ethos and professionalism.”.

 Putting regulation inside the central bank could diminish the independence of the central bank particularly in a crisis which could have an impact on monetary policy committee who could try and avoid harming the public sector.  So there needs to be some form within the central bank away from the governor of the central bank, from the regulator authority, subsidiary, separate committee which is happening the UK. There is also the risk that the central banks lose creditability if there is a financial crisis. However banks got blame regardless so might as well take responsibility. There are also arguments that central bank do not react harsh enough when faced with a crisis. On the other hand they may over regulate to protect their reputation. So this debate highlighted a lot of arguments both for and against the Bank of England taking charge of regulation once again, will it work? Only time will tell…  

The FSA - Where it all Went Wrong

This Blog will firstly establish the major failings of FSA in the most recent financial crisis. The best way to tackle the failure of the FSA is to look at arguably the two biggest failures in the British banking system and they are RBS and Northern Rock.

Beginning firstly with Northern Rock, the FSA failed on numerous grounds to pick up on this institution failing banking model. The first ground as highlighted by the government report “Run on the Rock” was the ARROW assessment used to evaluate levels of risk was not due for another three years gap between January 2006 and January 2009. Mr. Sants (head of the FSA) even said himself the proposed interval between assessment was” inadequate”. Another failing of the FSA was that they failed to pick up on two very important signs, first the rapid growth of Northern Rock and to use the old cliché if something is too good to be true it usually is. The next important signal was the falling share price as Professor Buiter “There is some information surely in the fact that Northern Rock’s share price had been in steep decline since February of this year, well before the financial market turmoil hit”. The share price of Northern Rock can be seen below (yahoo finance):

To put it as simple as Professor Wood (commentator on the financial crisis) did, The FSA feel asleep on the job as it failed to carry out correct stress testing procedures, liquidity checks and pick on the fact that the northern rock was a failed business model.

Now to talk about RBS, the best way to describe this is by watching this video:

This video discusses the report into why RBS failed and according to the report it failed for three main reasons "poor management, inadequate regulation and a flawed supervisory system". Also in this video Lord Adair Turner (chairman of FSA) describies how the FSA failed to regulate RBS. One case in particular that many critics pick up on was their merger with ABN AMRO, which everyone in the market knew it was going to be a complete disaster but the FSA failed to act. So with all these failings in mind there is a change on the horizon.