Parliament Libor Report: Both Banks and Regulators need to change

Parliament's Treasury Select Committee led by Andrew Tyrie issued a report on the Libor rigging scandal in which it concluded:

Among its wide-ranging conclusions were that Barclays operated for years with woefully inadequate controls, that senior staff at the bank should have taken action earlier, that the Financial Services Authority (FSA) failed in its duty as regulator to respond to rumours of rate-fixing, and that the Bank of England had been “naive” and “inactive”. 

“Public trust in banks is at an all-time low,” Andrew Tyrie, chairman of the TSC, said. “Urgent improvements, both to the way banks are run and the way they are regulated, is needed if public and market confidence is to be restored.”

This conclusion applies not just to UK regulators, but to EU and US regulators too.

In his Telegraph column, Damian Reece discusses the implications of Parliament's conclusion:

But what we’re also left with, yet again, is a story of regulatory failure. Since 1997 the UK has been plagued by porous rules that have allowed unalloyed avarice to seep into every nook and cranny of City life. 

It is Tyrie’s conclusions and recommendations in this area which are the most important elements of the report. 

The committee has quite rightly used its findings into the Libor scandal as ammunition in its attempts to get urgent changes made to the legislation passing through Parliament that will merge two failing institutions (the Financial Services Authority and the Bank of England) into one, even larger, failing institution. If we don’t get the future of regulation right, we’ll never get the future of banking right.

Please re-read the highlighted text as Mr. Reece has elegantly made the case for why we need to bring transparency back of every opaque corner of the financial system and create the 'Mother of All Financial Databases".  Everyone knows that sunlight is best disinfectant.

By requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, bank behavior can be changed and avarice held in check.

The regulators failed in the lead up to the financial crisis.  Libor is simply another example of their failure.

The only way to get the future of regulation right is not to let the regulators operate behind a veil of opacity. There is no reason to put the financial system at risk of failing again because the financial regulators fail once again to accurately assess the risk in the banks and the rest of the financial system.

Transparency reduces, if not eliminates, the financial markets dependence on the regulators as market participants can assess the data for themselves and adjust the amount and price of their exposures accordingly.

Tyrie’s report does highlight how the FSA, led by chairman Lord Turner, has shown glimpses of the so called “judgment-led” regulation that will be the founding principle of the new regime. 

Judgment-led regulation is the notion of regulators standing toe to toe with bank chiefs and telling them when they don’t like what they see on their balance sheets and informing them what needs to change. It’s about telling a board that changes need making to key personnel. The banks will hate it but that’s exactly the point. The quid pro quo is that at least some of the petty box ticking will be abolished that drives bankers wild and probably encourages, rather than discourages, the culture of pushing regulatory boundaries to the limit. 

Here is a classic example of the Financial-Academic-Regulatory Complex (FARC) trying to protect itself and expand its power.

A problem the financial crisis exposed is that regulators are not a reliable substitute for the market in enforcing discipline on banks.  Yet, judgment-led regulation is based on the notion of the regulators going toe-to-toe with the banks.

How dumb is that?

To enforce discipline, the regulators first have to be able to assess what is going on at the banks.  Without ultra transparency, the regulators are substituting their analytical ability for the markets' analytical ability.

It is well known that the market does a better job of analysis as it has much more in the way of resources (financial and expertise) as well as an incentive to do a better job than the banks.

To enforce discipline, the regulators then have to go toe-to-toe with bank executives. This is regulators substituting their machismo for the market.

Given the recent Standard Chartered money laundering scandal, we can see that the regulators are going to back down.  If engaging in $250 billion of money laundering with Iran after entering an agreement to prevent this practice is not enough to lose a banking license, bankers have nothing to fear from regulators other than a fine which is an insignificant cost of doing business.

Markets are much bigger than the banks and much more capable of meting out discipline than regulators.  This discipline takes the form of reducing bank stock prices and access to funds to reflect the performance of the bank.

But Tyrie’s report also reveals how Lord Turner and his counterpart at the Bank of England, Sir Mervyn King, were unable to exercise that judgment-based regulation properly when it came to the removal of Bob Diamond. They wielded the axe in an arbitrary way which was inappropriate and which cannot be tolerated. 

The fact that Lord Turner tried and failed to secure Diamond’s resignation and subsequently had to get Sir Mervyn involved also exposes him as a weak operator. Put this together with the fact that the FSA, along with the Bank, failed to spot Libor manipulation in the first place and that “doesn’t look good” to quote Tyrie once again. It doesn’t look good for the FSA but neither does it look good for Lord Turner’s candidacy to be the next Governor of the Bank of England, with supreme power over all financial regulation. 

So what have we learnt? We’ve learnt that the old guard has had its day. It’s changing at the banks but now it must change at the regulators too.