Regulating integrity

Adam Smith once said that "Virtue is to be more feared than vice, because its excesses are not subject to the regulation of conscience". Perhaps a slightly funny way to look at the world, but i think it's a pretty insightful way to think about how we go about regulating the important institutions in society.

As the world is in the process of looking to apportion blame for the current financial crisis it seems that the majority of blame is being position squarely at the door of the worlds banks. The truth is that it's not really as simple as that, but thinking like that will keep things simple as people try to understand the process that led to their home being reposessed. The worrying knock-on effect of simply blaming "the banks" for this mess is that what is likely to follow is a whole raft of very poor regulation, that fails to increase the trust that once existed between each of us as individuals and these important institutions. People who work for banks, quite simply cannot be trusted, so to protect individuals from their wily ways swaths of rules will be introduced. We will move further away from the 'old' notion that Adam Smith points to, which is "regulation by conscience". I don't think it's too much of a stretch to suggest that one of the major causes of the current banking crisis was not insufficient regulation, but just poor quality regulation. The best form of regulation i can think of is this regulation by conscience...if i do something, do i fundamentally believe that in the grand scheme of things that this is a good thing to do. Good regulation, would create an environment where that would be the first port of call when making decisions, not to go and check the rule book. This is understandable a tall-order, as it involves a big mental shift across the system.

One of the rule books by which banks have been told to manage their capital and consequently their risk is the Basel Accords. The most recent version of this rule book, which was being put in place in banks across the world was catchily called "Basel II". Effectively this is a set of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of these recommendations is to create an international standard that banking regulators can use when creating their rules about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. In practice Basel II attempts to accomplish this by setting up complex risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to safeguard its solvency and overall economic stability. Interestingly (if you get your kicks out this sort of thing), the big shift between Basel I and Basel II, was to give the worlds big credit rating agencies a much greater role in the whole process (not exactly looking like a rock-star move that one)...in fact under certain forms of this rulebook capital requirements for banks to hold against particular loans was directly taken from the credit rating from Moody's or Standard and Poors. Very simply if either of this 2 said your asset was AAA rated, the capital you required against that asset was reduced to virtually nil.

In a very simple example, the basic capital requirement for a bank is 8% of it's asset portfolio. So if the bank has made £100 million worth of loans, then they would need to hold £8 million worth as minimum 'protection' against those loans turning sour.

Under the Basel Accords, If however you carved up your mortgage book (via securitisation for example) and retained only mortgage assets with AAA ratings then you would only need to keep a fraction of that £8 million worth of capital against your mortgage assets. This could be a brilliant way of boosting shareholder returns; say the £100mm worth of mortgages pay an income of £2million per annum then your return on capital (very simply) is £2mm/£8mm x 100% = 25%. If however you could reduce you capital by restructuring your mortgage book, such that your income dropped from £2 million to £1 million, but commensurately you dropped your capital requirement to £2mm, then you would have doubled your 'return on equity' - £1mm/£2mm x 100% = 50%. Magic. Your shareholders think you are a genius, and now on the same amount of capital as you started with (£8mm), under the same terms you could go out and lend 4 times as much. Your shareholders are going to love you magic CEO person.

One of the biggest money spinners for banks over the past few years has been more complex forms of that stated above. One of my main jobs at the investment banks i worked at involved discussing with clients how to structure investments in such a way as to make them compelling from a 'return on capital perspective'. The method of doing this involved looking into the Basel II rule book and restructuring investments for our bank clients so that they could legally reduce their capital requirement so as to increase their return on equity. The problem in reality is that you weren't actually doing anything to change materially the quality of the investments...it was a grand form of window-dressing, or in the more base terminology of a former colleague; 'polishing turds'.

A second, and similar trend that developed over the past few years was a change in international accounting standards for banks (this was the one that Lehman Brothers grabbed with both hands so successfully until it blew them up). Another catchily titled accounting rule, called IAS 39, made it favourable for banks to shift some of their loans off "banking books" and onto "trading books". The trade off was simple...if you put assets onto your trading book, then the capital requirement against those assets dropped (good) but in return for this little pick me up you had to 'mark to market' those assets on a daily basis and record the changes in value through your overall profit and loss account. This would likely have the effect of increasing the volatility of your earnings...but when the assets that you are holding increase in value you look great. The large scale transitioning of assets onto trading books, effectively meant banks needed less capital for the same size loan portfolio. Consequently Lehman Brothers (and others) were able to have assets to capital of astronomic proportions. When all of the assets on these books collectively started to fall in value the speed with which Lehman was taken from hero to insolvent was very rapid. This was another rule change that in principle was a good idea, but the agents who were living by it played by the rules, but didn't have incentives to grasp the goal of the rule change.


One question that i hope regulators who are looking at the world now will focus on is this - The Basel Accords in principle are an absolutely fine way of thinking about securing the safety of the worlds banking system, but in practice if the agents who are supposed to live up to these standards didn't care for the principle of what they were about in their 'regulation of conscience' then you won't get the outcome you are after. I think the results speak for themselves.