Fifteen years after Lehman, we still need to fix financial supervision

Fifteen years ago, the financial world became obsessed with bank capital ratios. For after Lehman Brothers imploded, there was a race to tighten capital and liquidity standards.

And this continues, even today. Right now, for example, the American government is trying to implement a new wave of Basel III rules, sparking a furious backlash from Wall Street figures such as David Solomon, head of Goldman Sachs, who snipes that the measures “have gone too far”.

This is partly just Wall Street whingeing. Before 2008, the capital cushions of the big banks were ridiculously thin, and the rules around subprime mortgage securitisation, for example, were too lax. The fact they have been tightened since is a good thing.

But not all of their complaints are misguided. Irrespective of whether you think capital rules are too tight, there is a much bigger problem now: the reforms of the past 15 years have been very unbalanced.

Most notably, while there has been endless noise about capital and liquidity standards, there has been a woeful lack of attention paid to other realms of finance.

Some of these sins of omission involve institutions: the mortgage groups Fannie Mae and Freddie Mac, for example, remain stuck in a bizarre legal limbo, while there is still far too little scrutiny of non-bank financial groups.

However, arguably the biggest silence of all relates to the nature of financial supervision itself. Even amid this frenzied activity around capital and liquidity rules, the question of how to fund and support the people who are supposed to be monitoring finance in the first place — ie the supervisors — has attracted little debate.

Or to put it another way, in the post-Lehman world, finance has looked like a football match in which the rules have been changed mid-game in multiple, mind-bending, ways — but without adding more referees, and giving them the resources and systems that would allow them to do their jobs intelligently. No wonder mistakes occur.

To understand this, it is worth perusing Good Supervision: Lessons From The Field, a new paper from the IMF. The title might sound dull, but the message is scathing.

The paper starts by noting that the IMF has repeatedly warned in recent years that the supervisory regimes in most western countries were deficient — but these comments have been ignored.

“Many advanced, emerging and developing economies [lack] independent bank supervisors with clear safety and soundness mandates, adequate powers, and legal protection in the conduct of their duty,” the IMF team declares. “Deficiencies in supervisory approach, techniques, tools, and especially corrective and sanctioning powers are also widespread.” Ouch!

To back this up, the IMF offers charts tracking these deficiencies. But recent history provides an equally potent illustration of the woes.

Before Silicon Valley Bank failed this spring, for example, there were multiple signs that it was deeply troubled. However, supervisors at the San Francisco Federal Reserve were either unwilling or unable to act on the problems — even though they could see them.

Similarly, the problems at Credit Suisse were also evident well before it collapsed in March. But the Swiss regulator sat on its hands, partly because the bank had not breached any of the capital and liquidity rules that had been carefully crafted — and tightened — in the past 15 years.

These failures cannot necessarily be blamed on individuals, the IMF stresses; instead, the real problem is the system as a whole. Most notably, without a proper level of resources, independence and respect, it is very hard for supervisors to act in a smart and proactive way. The incentive is for backward-looking box-ticking.

The good news is that many supervisors know this. The Fed, for example, released a long report about the failures of SVB. And Agustín Carstens, head of the Bank for International Settlements, recently admitted that “banking supervision needs to up its game”.

Some regulators are also trying to change both their internal practices and culture. Take the European Central Bank. Two months ago it unveiled an “action plan to build an innovative suptech [supervisory technology] portfolio” which uses digitisation to promote a more forward-looking and cross-border style of monitoring.

In reality, the ECB could have embraced this (sensible) shift even before the advent of “suptech”. But digital innovation makes it easier and, most importantly, offers an excuse to challenge internal cultural taboos.

But the bad news is that it will be very hard to create intelligent forward-looking supervisory structures unless the supervisors are given more autonomy. In the case of the San Francisco Fed, say, its supervisors should have shouted last year that ultra-loose monetary policy (by the Fed) was creating incentives for groups such as SVB to gamble dangerously with bonds. They did not.

Or to put it another way, it is always easier for policymakers to tweak capital rules — and blame greedy banks when mistakes happen — than to turn the mirror on themselves. Which is why the IMF report should be required reading, particularly on the anniversary of that Lehman shock.

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