UK has most to learn from French lesson

In 1999, in the wake of the Asian and Russian debt crises and the collapse of the Long Term Capital Management hedge fund, William McDonough, then the president of the New York Federal Reserve Bank and chairman of the Basel Committee on Banking Supervision, foresaw a revolution in bank regulation and supervision.

The new Basel II capital adequacy regime, now operative in the European Union as the capital requirements directive, would, he told me, represent a paradigm shift in how bank regulators do their job. Instead of armies of bank examiners trooping into the offices of the big banks and poring over their books, even assessing the risk of individual loans, the banks would become more responsible for regulating themselves. This was essential, he maintained. The banking business, with its use of complex new financial derivatives, its sophisticated mathematical credit rating models and its opaque off balance-sheet vehicles, were too complex for a run-of-the-mill bank examiner to understand. Instead, he said, much more highly qualified examiners "will not be counting the cash and checking the state of the loan portfolio…they will be assessing the bank’s ability to manage its overall risk".

And then there was Société Générale. The giant French bank disclosed last week, to an incredulous banking industry, that a single ‘rogue trader’ had speculated so wildly with its depositors’ money (SocGen admitted that a sum of €50 billion was at stake) that it imperilled its survival. Coming on top of the billions lost by banks across the EU as a result of the subprime securitisation mess, SocGen’s revelation was a body blow to the philosophy underpinning the brave new world not just of bank regulation, but also the yet to be finalised Solvency II regulatory regime for EU insurance companies and financial conglomerates.

Too many banks and other financial institutions have been too busy profitably rolling the dice in the global financial markets to pay enough attention to the scale of the risks they have been taking or to invest in the management oversight systems needed to even begin to do that job well.

Senior executives simply did not understand what Alexandre Lamfalussy, the first president of the institution which became the European Central Bank (ECB), describes as the "mind boggling complexity" of the products their highly paid staff were peddling.

Many banks did not bother, either, to put in place enough computing power and personnel to process the volume of deals they were carrying out. This will surely have contributed to the evaporation of confidence in the inter-bank lending market which is threatening to bring the global economy to its knees. In times of stress like these, how can you trust a counterparty which is not even able to assure you that your multi-million euro transaction has been completed?

The Bank of England on 2 January argued that among the many problems the current banking crisis has thrown up - they include inadequate attention to regulating bank liquidity and the ambiguous role of credit rating agencies - is the new Basel II capital regime. It tends to encourage loose lending in an economic boom and excessive credit rationing in a downturn which can aggravate the business cycle. Astonishingly EU finance ministers have yet to discuss in detail long-standing ideas, adopted by Spain and propounded by the Bank for International Settlements, aimed at creating a more counter-cyclical regime. Neither, it seems, have they focused in detail on the merits of the Dutch banking regulatory regime which, like Ireland’s, instead of rigidly separating monetary policy and bank regulation, gives the central bank a big role in monitoring financial stability.

The potentially catastrophic breakdowns in Europe’s financial markets, beginning last summer, including at UK bank Northern Rock, have exposed the inadequacy of bank regulatory structures only recently put in place. These have failed to keep up with the pace of innovation and cross-border integration in the banking industry. Petty, rushed tinkering is not a solution, indeed it could make things worse by encouraging banks, which are already rationing credit out of fear, to tighten up their lending further. There is plenty to do, from focusing regulation more on liquidity to re-thinking the status of credit rating agencies and working out how monetary policy and bank regulation can work together better in a counter-cyclical way.

It is this month’s report of Britain’s House of Commons Treasury Select Committee, however, which, embarrassingly for the UK, has put its finger on the most important change needed. The central banks, in London the Bank of England and in Europe the European System of Central Banks, must be given a much bigger role in monitoring financial stability. The badly needed shift in this direction is going to expose Britain’s opt-out from the single currency as hard to reconcile with its role as Europe’s dominant international financial centre. Tant pis.

• Stewart Fleming is a freelance journalist based in Brussels.

In 1999, in the wake of the Asian and Russian debt crises and the collapse of the Long Term Capital Management hedge fund, William McDonough, then the president of the New York Federal Reserve Bank and chairman of the Basel Committee on Banking Supervision, foresaw a revolution in bank regulation and supervision.