In defending Sir Mervyn King, the Telegraph's Liam Halligan underscores why financial stability must not be reliant on regulators

In his Telegraph column defending Sir Mervyn King's track record and agenda, Liam Halligan shines a very bright light on why the stability of the financial system must not be dependent on regulators.

Mr. Halligan shows two ways in which a regulator can be captured:  by politicians and by the firms it regulates.  Both forms of regulatory capture undermine the ability of the regulator to do its job and contribute directly to financial instability.

Readers will recall that when financial reforms were passed during the Great Depression regulators were suppose to complement and enhance market discipline.  Not replace it.

For example, in the 1930s providing ultra transparency and disclosing on an on-going basis its current asset, liability and off-balance sheet exposure details was a sign of a bank that could stand on its own two feet.  Bankers expressed concern that this practice would come to an end with the introduction of deposit insurance and regulatory oversight.


By 2012, not only has the practice come to an end, but the Bank of England's Andrew Haldane says that current disclosure practices to all market participants other than regulators leave banks looking like 'black boxes'.  This cements in both replacing market discipline with regulatory oversight and the market's reliance on the regulators to properly assess and communicate the risk of the banks.

It is this reliance that compounds the financial instability that occurs from regulatory capture.

Your humble blogger has been advocating for requiring ultra transparency to end this reliance and reduce the financial instability caused by regulatory capture.

Return to Mr. Halligan,

It needs to be clearly and widely understood, though, that the City is trying to destroy King's reputation for the simple reason that he is pretty much the only senior UK policy-maker still arguing for the kind of robust bank regulations, much tougher than those currently proposed, that are needed to prevent another serious financial meltdown. 

The negative-publicity campaign against King, years in the making but seriously escalated last week, is being staged by the same "vested interests" which he, almost alone among Western central bankers, has dared to face-down. As such, the investment banks drip their poison, the PR agencies punt it and knocking-copy sells papers – not least when times are tough. 

The Governor is determined to do everything he can, before his term expires in June 2013, to rein-in UK banks.

Hence the reason that Sir Mervyn King is a logical champion of ultra transparency.

The City doesn't want that, of course. So history is being re-written, with King being accused of all manner of things in order to undermine his authority. 

I don't remember, for instance, King "allowing the bubble to inflate" prior to the credit-crunch. On the contrary, he was often attacked by business lobby groups for being too hawkish. 

Example number one of regulatory capture:  firms being regulated.

In August 2005, lest we forget, King was out-voted when he tried, amid signs credit was over-heating, to prevent interest rates being cut. The casting votes against him came from external MPC members appointed by then Chancellor Gordon Brown.

Example number two of regulatory capture:  politicians.

Similarly in June 2007, again as credit was spiraling, King tried to raise rates. Again he was out-voted, with Brown placemen playing a crucial role. So let us not say King was soft on inflation or credit in the run-up to sub-prime. Let us stick to the facts. 

The reality is that King did see the credit crunch coming. Among several warnings he gave, the one that sticks in my mind was at the Lord Mayor's Banquet, also in June 2007. 

"Excessive leverage is the common theme of many previous financial crises – are we really so much cleverer than the financiers of the past?" King publicly observed, as the City boys pursed their lips. 

"It may say champagne – AAA – on the label," King boomed, criticizing sales of complex derivates approved be deeply-compromised ratings agencies. "But by the time investors get to what's left in the bottle, it could taste rather flat". 

King's words of June 2007 were truly extraordinary. What more could a Bank of England Governor have said, without being accused of spreading panic?

Here is an example of the problem that regulators have in communicating risk.  How exactly can risk be communicated so that it does not set off a panic?

This is one of the reason for ultra transparency.  With everyone having access to the data, then risk can be discussed:  as in, 'our analysis shows that risk is building up ... are other participants seeing what we are seeing?'

And when it comes to his "lack of market knowledge", King didn't have detailed break-downs of each banks' balance sheet because the bank supervision had been transferred to the (Treasury-controlled) Financial Services Authority back in 1997.

Requiring ultra transparency would eliminate this as a problem.

In fact, if the reason for putting regulation and supervision under the Bank is to eliminate this problem, ultra transparency does a better job.  With ultra transparency, the Bank is free to independently analyze the data and draw its own conclusions without worrying about bank supervision.

Please note, in the run up to the financial crisis, the Fed, which had both monetary policy and supervision authority, also failed to prevent the crisis.

Brown set up the FSA because he wanted to control the bank regulator. The then newly-minted Chancellor wanted to keep the UK's lending boom going, in the misguided hope that the resulting "feel good" factor would make him the UK's most popular politician. 

So King was right last week, when he said the FSA was "a reform that would return to haunt us". He was right to defend the Coalition's measures to bring bank regulation back to Threadneedle Street. 

I also believe he was correct, when the credit crunch first hit, to make the banks sweat, questioning unconditional root-and-branch bail-outs. "Moral hazard" isn't an academic parlour game. It's the reason why the Western banking system collapsed and why, unless drastic reforms happen, it will ultimately collapse again. 

As discussed elsewhere on this blog, adopting the Swedish model eliminates the issue of 'moral hazard' and bank bailouts.  The Swedish model allows banks in a modern financial system to perform their function of protecting the real economy by absorbing all the losses on the excesses in the financial system.

No-one is saying King is beyond reproach. The Bank's "quantitative easing" programme, which King has supported, has been grossly over-extended. Few have criticized it more than me. 

Yet King was presented with a fait accompli. Downing Street was, and remains, determined to print virtual money, taking the line of least resistance. I wouldn't be surprised if King finds such policies as distasteful as I do. He could have resigned, but what then? There would have been an almighty panic, with King anyway replaced with someone even more flexible in their understanding of basic economics. 

What really got the City's goat about King's latest speech is his on-going determination to separate "ordinary" retail banking from "risky" investment banking. 

It is vital, said King, that the Government brings the Vickers reforms into law "sooner rather than later". These changes, which "ring-fence" investment and retail banking in the same institution, aren't set to bite until 2019 – long enough for the banking lobby to water them down even more. 

King signalled, as he has before, that Vickers doesn't go far enough. "We don't build nuclear power stations in densely populated areas, nor should we allow essential banking services and risky investment banking activities to be carried out in the same 'too important to fail' bank". 

King then referred, albeit in coded language, to the massive off-balance sheet losses still smouldering, unaudited and undeclared, within the UK banking system. During the financial crisis, "it was difficult to know which banks were safe and which weren't", King boomed. 

And it still is.

In the aftermath of the Northern Rock collapse, "banks found it almost impossible to finance themselves because no-one knew which banks were safe and which weren't". That remains largely the case today....

I know I am repeating myself, but the only way to solve this problem is requiring ultra transparency.

Within the Square Mile, King's latest speech was a declaration of war on a banking sector that has wrecked our economy, been mollycoddled and remains astonishingly bloated.
Little wonder the money-men have buried the Governor's message under a pile of self-serving vitriol.

Hence the reason that it is important that Sir Mervyn King fight the right battle.  Ultra transparency will do far more to improve financial stability and reduce the risk of the banks then any regulation like ring-fencing.  Remember, Glass-Steagall was the ultimate ring-fence and it fell to the banks in under 60 years.