23 March 2008

FT: Beware a regulatory backlash against banks

Banks are focused on the current crisis but they should keep their eyes on another looming problem: a regulatory backlash that is already under way in some countries. It will be costly and will have unintended consequences.

The political dimension is broadening as the banking crisis feeds into the real economy. The US could already be in recession, the UK is slowing down and European Union growth forecasts have been scaled back. As people see the value of their homes fall, find banks less willing to lend money and feel the effect of rising inflation allied to average wage growth that has already not kept pace during the boom years, the calls by bankers and some regulators for measured reactions may not be listened to.

In the US, with an unpopular out­going administration, no action is expected until 2009, at which point, analysts believe, US banks will be cudgelled with new laws – and in view of the US bias towards extraterritoriality, this will also probably affect foreign banks doing business there. But in the UK the backlash has begun and it may provide some indications of what will happen in other jurisdictions.

A consultation proposal on financial stability and depositor protection, launched in January by the Treasury, the Financial Services Authority and the Bank of England, has 29 legislative proposals and 23 significant policy initiatives to do with operational changes, plus rule changes on which the FSA plans to consult, notes the British Bankers’ Association. The consultation period – bankers argue there has been little of that – finishes on April 23 and legislation is to be introduced by the summer, a breakneck speed for the most far-reaching changes to the banking regime in a decade.

That probably means the legislation is already being drawn up. It looks likely to include new insolvency arrangements for banks that will have far-reaching implications for property rights and might well complicate the impact of failing banks. Additionally, there is a proposed “single customer view” – to bring together information on customers in different databases – that would force banks to spend vast amounts on upgrading their infrastructure. The document suggests banks that cannot yet provide that sort of information will find “commercial benefits” in doing so. Perhaps since nationalising Northern Rock the authorities believe they know more than the private sector about bank strategy.

The proposal looks at pre-funding depositor compensation arrangements. Such a regime, with a £13bn pot, would take money out of the system while being irrelevant to ensuring a speedy payout, notes Richard Lambert, ­director-general of the CBI, the UK business organisation.

Separately, bankers’ remuneration could become a target for regulatory moves in the UK and the US. Although it is difficult to see how governments could get involved in the intricacies of tying reward to risk, that does not make it impossible in a heavily regulated industry dependent on government goodwill in countless ways.

Spectacles such as that of Stan O’Neal, former Merrill Lynch chief executive, at a hearing in Congress in March excusing his $161m retirement package as “deferred compensation, stock and options that I earned during the years prior to 2007” provide politicians with ammunition.

Charlie McCreevy, EU internal market commissioner and a friend of the financial services industry, has said that to avoid a regulatory backlash, banks must step up to the mark “not with a grudging, de minimis approach – but with real leadership and commitment”. So far that looks unlikely, as can be seen, for instance, from the damp squib of a decision to elaborate a code on bankers’ pay at the spring meeting of the International Institute of Finance in Rio de Janeiro. Getting banks to agree on measures that will forestall politicians is almost impossible, because banks that are less exposed see no need to make common cause with those that have problems.

It is indisputable that changes in regulation are needed – as well as modifications to Basel II capital requirements and International Financial Reporting Standards. However, time is required to consider the full implications of any changes and, at least in the UK, that looks unlikely. The authorities’ proposals look to be as harmful to the UK as was Sarbanes-Oxley to the US. The banks need to think about how they can contain this regulatory backlash.

By Karina Robinson

© Financial Times