Financial Regulation

Pro-free market government policy in the UK and US since the 1980s has led to a global drive for financial market deregulation. What impact did that have on the Financial Crash?

What went wrong?

The beginning of the financial crash can be traced back to the deregulation of finance in the 60s and 70s, including both the relaxation over credit creation and interest-rate setting, and then later as a result of the ‘Big Bang’ in 1986. Further financial deregulation of city institutions then enabled London to become a leading global financial centre. This was later described by Gordon Brown, as “the beginning of a new golden age for the City of London”.

During the ‘Golden 1990s’ the banking sector took particular advantage of deregulation, devising diverse, complex financial instruments while expanding credit and setting high real ‘market’ interest rates on loans. Credit was provided on the basis of the ability to pay high rates, rather than projects’ viability and income-generating ability. In addition building societies were transformed into private banks, thus increasing the financial sector’s exposure to higher rates and falls in in real-estate values.

In both the US and UK, banks dispensing mortgages took on more and more risk to increase their short-term returns, hiding risks through sophisticated financial instruments known as ‘securitisation’. This led to increasing levels of debt that were unsustainable and the sudden realisation that many were unable to repay or roll them over, set off a chain reaction of defaults and bankruptcy.

The bankruptcies of US banks

The crash took the financial world by surprise. As Alan Greenspan, former US Federal Reserve Chairman wryly noted to the US House Committee on Oversight and Government Reform on 23 Oct 2008,

I had been going for 40 years or more, with the very considerable evidence that the market was working exceptionally well.

From a financial regulation perspective, the Financial Services Authority (created by New Labour) admitted striking failures in terms of their supervisory role, and was roundly criticised by the Treasury Select Committee on 26 January 2008.  Later, both David Cameron and Vince Cable would also criticise this failure.

“It is critical that the FSA sets itself higher standards in the future…simply asking for more staff is not the answer” Vince Cable, later Liberal Democrat Shadow Chancellor, 27 March 2008.

However potentially the problems could be more systemic and deeper. In a YouGov report on Public Trust in Banking, a senior banker compared the banks to “overenthusiastic waiters at a party, who were happily drinking themselves and happily giving everybody too much to drink. You have also got to think who bought the drink and whose party it was. So absolutely they were excessive as the waiters, but it’s not the whole story”. Prophetically perhaps as a consequence of this failure to come to grips with the broader responsibility, they predicted that “the socio-political aftershocks of the crisis are actually likely to last longer than the economic ones”.

What were the impacts?

As problems emerged, during the course of 2007 the US Central Bank reduced interest rates dramatically as banks and other sub-prime mortgage lenders experienced difficulties due to lagging repayments and a drop in the value of their collateral (houses).

In the UK, the stock market, reeling from these events, experienced volatility and by mid-2007 banks stopped lending to each other. By September 2007, Northern Rock (Britain’s fifth biggest mortgage provider) sought emergency funding from the Bank of England. At the time, its CEO Adam Applegarth exclaimed,

I didn’t see this coming, I have yet to find someone who did.

In the resultant fallout, with banks, including the Royal Bank of Scotland, in trouble, the Bank of England resorted to nationalisation, lowered interest rates significantly, and injected billions of pounds of bailouts and loan guarantees to financial interests. As a result, rather than suffering consequences, these banks, which were deemed ‘too big to fail’, received further guarantees that they would be bailed out in future.

By April of 2009, the UK had experienced the biggest surge in unemployment since 1981.

What has happened since?

The aim of the 2010 Basel III Accord (a set of banking regulations) was to reduce banks’ financial risks by requiring them to hold more collateral. But many commentators, such as Andy Haldane in his famous 2012 speech “The Dog and the Frisbee” (PDF) have suggested this is overly complicated and ineffective.

Total cash support for the financial industry in the aftermath of the crisis reached almost half of the UK’s annual Gross Domestic Product. Furthermore, both parties made it clear post-crisis that financial sector reform should not jeopardize the international competitiveness of the ‘City’ (of London). As such, proposals such as a substantial increase in bank levies to fund a “deposit insurance scheme” (to protect savers) have failed.

A key moment occurred in 2011 when the government released a White Paper on future banking regulations. Firstly, this created a new regulatory body (The Financial Policy Committee) that has developed schemes to require ‘systematically important banks’ to hold an additional 3%-5% reserves. Secondly, the ‘stress tests’ used to evaluate the financial soundness of banks were to be more rigorous (than the European standard). Thirdly, the FPC also judges the ‘risks’ that banks use to evaluate the reserves to set aside for emergencies. Fourthly, as the crisis was initially sparked through the real-estate sector, the FPC has been granted powers to limit mortgage lending. While the banks initially resisted these changes, the government was helped by public opinion, and financial institutions have stopped arguing that these measures have lowered lending and have raised interest rates.

More stringent regulation has forced financial institutions to carry more reserve cash (for emergencies/crises), which has improved bank practice to some degree. However many claim that the culture of banks to take high risks and avoid regulation has not changed.

What is the future outlook?

It is not clear whether these new rules can prevent further banking crises and the existence of rules does not imply that they will be applied as intended. Certainly critical commentators such as Ann Pettifor see no significant change [see the Mint interview]. Steve Keen also sees the level of debt as suggesting that further crises are on the way. Even more free market-orientated economists are critical of the regulatory regime (e.g. Kevin Dowd at Durham University).

There is also pressure from the new US administration to dismantle regulations altogether and Brexit may lead to a UK strategy to deregulate to defend the finance sector [see article on ‘Singapore on the Thames’ in The Mint].

There remains the question as to whether the culture in banks can change. Some such as David Pitt-Watson of the London Business School suggest an essential element of this is for banks to focus on their purpose of providing a service.

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