The Rock and his Millions

Geoff’s entry today here prompted me to write something topical for once, so I’m going to follow up on this enlightening review. Despite everyone clamouring for change (from more staffing to a rehaul of the entire system), nobody actually knows what actual reforms are going to be implemented, aside from how we’re promised that things will be “better”. Somehow it reminds me of a certain someone’s campaign, but let’s not get into that. Instead, I’m going to discuss the theoretical side of how this discovery may affect the future.

As Robert Peston rightly pointed out, this is likely the most interesting insight gained into the mindset of the FSA:

“Our understanding is that, during the review period, the FSA’s approach to liquidity reflected a presumption that, in the event of a crisis like that experienced in August 2007 (when money markets seized up), general market liquidity provided by the Bank of England would be increased and, in extremis, liquidity would be provided for systemically important institutions”.

What frightens me is the future implications of this expectation. The keyword here is moral hazard. When even the regulators expect their clients to be bailed out, there are no incentives for the banks themselves to act prudently and take the appropriate amount of risk. This was exactly what the BoE was scared of – a sign of weakness now will set a precedent for future generations to come, and signal to the other banks that’s it okay to take on even more unnecessary risk.

The whole time the FSA has been running, it has been regulating under the expectation that the Bank of England would bail out any major banks unfortunate (read: risky) enough to get themselves into trouble. This almost certainly means that it has been too lax with its controls, and we saw the impact of that most clearly over the summer of course. Somehow the watchdog decided that Northern Rock was the least risky bank in the UK rather than the most. The advocates of Stigler must be rubbing their hands with glee right about now, for this is a prime data mine for evidence of regulatory capture. It wasn’t just that the watchdog was incompetent; it was wrong in its expectations due to the plain inadequacy of communication and understanding between the two governing bodies.

However, it’s interesting to note that the review (suspiciously carried out by the FSA themselves) continued to laud its own philosophy of operating within a framework of principles-based regulation, rather than rules-based. Even though a major agreement has been struck that fundamental reform was necessary, we don’t want a knee-jerk reflex as damaging as the Sarbox.