London Banks, Falling Down
Britain's financial system was until recently hailed as a model for the U.S. Not anymore.
Americans are conditioned to think of Europe as a giant bureaucracy dotted with some old churches and nice restaurants. But in reality, London, as recently as two years ago, was a laissez-faire paradise. Banks and other financial firms could get by with even thinner capital cushions than their American counterparts. Rather than dole out punishments, regulators opted for negotiation-friendly dialogues over tea.
This made London seem like a threat to New York's reign as financial capital of the world. Egged on by the business and Wall Street lobbies, American politicians worried that New York was losing out, partly because of the oversight imposed by the Sarbanes-Oxley Act.
Now, however, the British capital is mired in as great a crisis as New York's-and things are about to get worse, making a mockery of the insecurity complex regarding Britain that hit U.S. business leaders just months ago. Given that both countries are dealing with the same credit crisis, this should make us wonder why the two regulatory regimes, so different in structure, have each failed.
British bank stocks have plummeted in the wake of last year's rescue attempt and subsequent failure of Northern Rock, a midsize bank whose customers were seen on the evening news lining up to withdraw their money. Britain's surviving banks are scrambling to raise capital, with some having less success than others. The deflation of the British housing bubble has only just begun. Prices, which rose at roughly double the U.S. rate over the past decade, tumbled about 10 percent from their peak in August 2007 through the middle of this summer. Inflation and unemployment are rising, and Britain is in a bear market.
Things might become worse in Britain than in the U.S. Consumers are more indebted; financial services make up an even greater portion of the economy; inflation takes a much more significant bite because the British have to import so much.
What seemed like a prospering and unfettered free market has turned ugly. The two countries' respective problems are related to financial excesses, but Britain seems further down the path of examining the faults and weaknesses in its financial regulatory structure.
We need to do the same. Then we can learn from London about what-and what not-to do.
In the U.S., problems started when home prices merely stopped rising, revealing the bad loans the financial sector had made. Subprime borrowers couldn't refinance and began to default on their mortgages. Home prices dropped, and the credit problems spread beyond subprime. Britain's troubles, in contrast, started not from credit problems but from banks' reliance on short-term funding rather than deposits. The thin capital cushions suddenly became serious vulnerabilities. "It was presumed that the market simply wouldn't deal with undercapitalized financial institutions. U.K. banks and insurance companies were allowed to run with much less capital than similar American institutions," says John Hempton, an Australian financial analyst and expert on British markets.
Regulators allowed this skating on thin ice because they were weak. The British regulatory agency, the Financial Services Authority, has sweeping jurisdiction over the British financial world, yet it rules diffidently.
In the U.S., the Securities and Exchange Commission, and with it most of our financial regulatory framework, was created in the midst of a crisis, the Great Depression. The F.S.A. wasn't formed until 1997, when the financial sector was politically and economically powerful. The British agency as we now know it was created following a decade of failed self-regulation.
Unfortunately, the political will didn't exist to both create a regulator and have it actually do much. "The philosophy of the F.S.A. from when I set it up has been to say, 'Consenting adults in private? That's their problem, really,'" says Howard Davies, the agency's first chairman, who is now the director of the London School of Economics and Political Science.
For a while, this hands-off approach seemed like the right answer, especially when viewed against the Dr. Seussian American system, in which multiple agencies, often with overlapping jurisdictions, compete against one another.
"We are a much freer market, much more lightly regulated," says Bob Penn, a London securities lawyer for Allen & Overy. "But ultimately, the regulators are just too timid about market abuse. We don't have particularly clean markets." The F.S.A., it turns out, has pitifully staffed and funded enforcement operations compared with the S.E.C. Though the London markets are about a third of the size of their U.S. counterparts, the F.S.A. has a mere 98 enforcement agents to the S.E.C.'s 1,111.
Of course, the financial world likes the light touch of the F.S.A. But amid panic about the solvency of financial institutions, the world is learning the value of a regulator that has the market's respect. When Northern Rock started having trouble, the banking regulators at the F.S.A. dithered and fumbled. Northern Rock went under. The F.S.A. publicly flogged itself, and heads at the agency rolled. But the damage to the market was done, reflected in the financial sector's continuing collapse.
This isn't to say that American regulators have done much better. The S.E.C. is bigger and more professional and was more willing to wield its enforcement powers than the F.S.A. was, but S.E.C. chairman Christopher Cox has largely been missing in action during the credit crisis, most prominently on the weekend that the Federal Reserve brokered the J.P. Morgan takeover of Bear Stearns.
To distract from the mess, regulators on both sides of the Atlantic are staging a sideshow of rousting speculators. The hunt is on for the sowers of hate and fear among us, the short-seller behind every bush. The F.S.A. has proposed some modest rules advocating short-position disclosure while banks are in the middle of selling stock to raise cash.
Here, we've been treated to the spectacle of hastily drawn rules and publicly announced investigations that are more P.R. campaign than substantive response. You keep expecting Cox to rise before a congressional committee and shout, "I have a list! There are 150 secret short-sellers in the market! A list of 150-no, wait-160 known short-sellers!"
This is what's meant by the term moral hazard: Investors who get in trouble are then bailed out, and thus have little incentive not to do it again. Yes, runs on financial institutions can happen. But the risk of a run requires financial firms to manage for the possibility. The threat should curb their recklessness. If they know, however, that when things get bad, the government will hinder betting against them, seek out those who speak ill of them, lend to them cheaply, and generally backstop them, then they have every reason to take huge risks in the future.
We're in a dangerous phase. In a crisis, you can either go toward fearmongering and scapegoating or toward real reform. But I'm an optimist. I think that after the denial, anger, and acceptance, after the failures, bankruptcies, losses, witch hunts, and punishments, we will come to realize that we have to rethink the way we regulate our financial system.
it's noteworthy that both the U.S. and British economies have similar problems-and it's not that both are plagued by secretive malign forces. Both countries are filled with bad loans and overleveraged institutions. Britain has the right structure but the wrong approach to remedy its problems. The U.S. has the wrong structure and, in recent years, the wrong approach.
We can still learn from the rest of the world. An F.S.A. would work in the States, provided it had teeth. It isn't enough to reorient the S.E.C. toward enforcement after the neglect of the Bush-Cox era; financial regulation in this country needs a wholesale revamping. Regulators will need to focus on capital requirements. In Britain, this is already taken as a starting point. Over there, people are also contemplating regulation of banker pay to better align incentives. That's highly unlikely here now, but the problem is clear: Bankers on both sides of the ocean are rational in taking big risks because the state protects them from serious consequences. Furthermore, monetary authorities will have to monitor asset bubbles and assume responsibility for deflating them.
Most of all, we need to restore the good name of regulation. For many years, the U.S. stock market provided the highest returns in the world yet was more regulated than foreign exchanges. Regulation and returns aren't mutually exclusive. One leads to the other.Visit Portfolio.com for the latest business news and opinion, executive profiles and careers. Portfolio.com© 2007 Condé Nast Inc. All rights reserved.
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