In the old days, in so far as they worried about the risk of banks going bust, regulators usually relied on simple measures of health, concentrating on making sure the right paperwork was in the files, says one senior regulator. “It was a wood-and-trees problem,” says another official. “You would go in and come up with a list of 45 things a bank could do better, but you would not be saying: ‘What are the five important things that could threaten this bank?’”
In the new world of regulation, supervisors are still doing some of the things they have always done. They are tightening capital standards and looking far deeper into the inner workings of banks, down to the plumbing that connects them to one another. “Regulators have gone from saying ‘tell me all your [payment] systems work’ to saying ‘show me how they work’,” says Simon Bailey, of Logica, a technology firm. “They are shining a pretty bright light on parts of the banking system that are massively complex and, if I’m being polite, slightly dusty.”
Far more controversially, though, regulators are now also tentatively stepping over a long-standing divide between enforcing basic rules and playing a part in business decisions. In regulator-speak the difference is between “conduct regulation” and “prudential regulation”. Under the old rules supervisors were simply referees trying to ensure that the game was played fairly....
At first glance it seems sensible that regulators should pay attention to banks’ health as well as to their conduct. Regulation, after all, is the price that society demands, and banks pay, in return for the implicit promise of a government bail-out if the worst happens. The reason banks are regulated and hairdressers are not is that a badly run barber poses little danger to outsiders. Banks, on the other hand, cause widespread chaos when they collapse. One sick bank going broke can destroy confidence in the entire banking system and start runs that could bring down healthy banks too. Most advanced economies try to prevent that by offering deposit insurance to savers. They also regulate banks to make sure they do not gamble with savers’ protected deposits.
But it is not easy to stop banks from making bad decisions. In the past regulators have tended to leave it to the market to judge the health of banks, not least because they themselves did not feel up to it. Legions of clever, well-paid investment analysts and investors failed to see the crisis coming. Those who did are remembered mainly because there were so few of them.
Now central bankers and supervisors are expected to make a better job of it, but most would prefer not to get too involved. “We don’t want to get into the business of making very close business judgments,” says one American official, but “we are making a judgment of our own about whether they have a coherent strategy and coherent risk management.”
One problem is that rules and laws are written with the benefit of hindsight. The good ideas that might well have prevented the last crisis, however, can make regulators dangerously overconfident about being able to predict and prevent the next one.
Besides, the regulators’ reluctance to second-guess bank executives was well founded, because it can take them onto dangerous ground. If regulators underwrite certain strategies that seem safe, such as lending to small businesses or helping people buy houses, they may encourage banks to crowd into those lines of business. That can drive down interest rates and lending standards and push up asset prices. If enough banks pile into these markets, downturns in them can affect not just a few banks but the whole system. Paradoxically, the very act of signalling that a market is safe can make it dangerous. It also introduces a form of moral hazard, because banks and their creditors may assume that the government would be duty-bound to bail them out if a closely monitored institution were to fail.
On the other hand over-strict regulation can also be harmful if it stifles financial innovation and squeezes all appetite for risk out of the banking system. In Japan, a banking crisis that started more than two decades ago still lingers on, in part because the country’s bankers have become gun-shy and tend to buy government bonds rather than lend money.
And even if supervisors rule wisely, they have to keep it up year in and year out to remain effective. “I worry that supervision is an endless process of having to get better,” says a senior regulator in Britain. “You have to keep hiring lots of clever people and you have to avoid atrophy over time.”
Most regulators are doing all they can to mitigate these risks. Many are concentrating on changing incentives in the banking system, in the hope that this will change behaviour. Yet they also know that in the new world of intensive regulation the very need for it is an admission of failure.