Bankers Running Rings Around Regulators

In 2009, as the financial crisis entered its darkest days, G20 leaders descended on London for a meeting aimed at bringing the world economy back from the brink.


President Obama outlined the "unprecedented steps to restore growth and prevent a crisis like this from happening again."

Banker bashing was rife, with Gordon Brown comparing the masters of the universe to children who needed some tough love.

"In our families we raise our children to work hard, to do their best, and do their bit. We don't reward them for taking risks that... put them or others in danger," said Brown as he hosted the G20 meeting which was painted at the time as the summit that saved the global economy.

Last weekend Brown admitted the great and the good meeting at the G20 that week in March 2009, when global equity markets bottomed, didn’t really understand what was going on.

“We didn't understand how risk was spread across the system, we didn't understand the entanglements of different institutions with the other and we didn't understand even though we talked about it just how global things were, including a shadow banking system as well as a banking system,” said Brown in a speech in New Hampshire in the United States.

"That was our mistake, but I'm afraid it was a mistake made by just about everybody who was in the regulatory business," he said.

Never Again

The principles set out at that G20 meeting have driven attempts to reform the way Wall Street and other financial centers across the world do business.

Unfortunately for those demanding major reform, the politicians and regulators had to turn to the very people they where trying to impose new rules on for advice on how this would be possible.

“The G20 reform drive yielded a set of principles regarding bankers’ remuneration and proposals to raise the capital that banks are required to hold against their assets,” said Stephen Lewis, the chief economist at Monument Securities in London in a research note.

“Both of these avenues of reform merely skirted the heart of the problem. That was hardly surprising. In a disarming admission, Mr. Gordon Brown last weekend conceded that he had not understood, before the crisis, how inter-connected financial institutions had become. Mr. Brown, in fact, probably spent more time studying these matters than did the majority of his G20 colleagues. If he was taken by surprise, so are they likely to have been”

Aware of the fact that they where ill-equipped to make tough decisions on banking, the politicians turned to those bankers lucky enough to have survived for advice on change the rules.

“Needless to say, the advice they received, while recognizing the political necessity of offering a few banker-bashing concessions, strongly favored preserving the structure of the banking system in its pre-disaster form. The politicians were warned that any other course would threaten global economic stability” said Lewis.

Same Movie, Different Ending?

The subsequent piecemeal approach to banking reform has been unsatisfactory according to Lewis.

“A striking example has been the Dodd-Frank legislation in the USA, which has required banks to desist from proprietary trading in capital market instruments. Dodd-Frank has failed to please anybody, however, partly on account of the arbitrary distinctions it draws between those activities that are proper to banking and those that are not, and partly because it is already seen to be failing as a means of preventing the revival of market practices that led to the 2007-08 crisis,” Lewis said.

Whether the reforms in place or to be put in place can prevent another crisis remains a big doubt.

“I think we have seen this movie before” said Ted Price, from Canada’s Office of the Financial Institutions last month. “But the amazing thing is we continue to expect a different ending.”

Lewis said a number of investment banks are now taking on more risk in order to meet profit targets.

“They do not apparently regard a reduction in those targets as an acceptable trade-off for operating in a safer financial system. As long as banks are driven by short-term profitability goals, it seems, there will be a bias in the financial system towards undue risk-taking and a significant chance that another systemic crisis will erupt,” he said.

“It will not make any difference to systemic risk that rules on pay have been introduced. If bankers do not know where future dangers to profitability lie, they will not know what to avoid, however they are paid,” he added.

Demanding that banks raise more capital has resulted in the banks pulling back from lending to consumers and businesses in Lewis' view.

“They achieve this restraint most directly by cutting their lending, action that weakens the economy and thereby raises the risk of loan losses for the system as a whole. More subtly, banks can shift business off-balance-sheet, into the ‘shadow banking’ sector. Though regulators claim they are watching such activity closely, pre-2007 experience suggests they might not know what they should be looking for,” he said.