The Bank of England Sows the Seeds of the Next UK Crisis

This column is the third in a series of discussions of the developing EU crisis inspired by discussions at the recent Kilkenomics Festival in Kilkenny, Ireland. This installment addresses two recurrent and related myths that are the enemy of effective financial regulation. • Control fraud by financial institutions can be ignored • Bank examiners and bank underwriting add little value and can largely be displaced by software This column warns of a disastrous desupervisory development by the Bank of England (BOE). The inspiration for this column (as with last week's column on silver bullet solutions to the Irish crisis) is Richard Field. Mr. Field has cheered the BOE's planned desupervision as implementing “21st Century Oversight.” This column also draws on the lessons that should be learned from Ireland's failed experiment with desupervision. The Wall Street Journal reported on November 17, 2010 that the BOE was junking the Financial Services Agency's (FSA) “intrusive” bank examinations and substituting off site data reviews. A bit of regulatory background is required to understand the issues. The UK's FSA was supposed to be 21st Century Oversight model. The concept of the FSA was to bring together all the relevant financial regulatory authority in a single agency in order to avoid “competitions in laxity” among rival agencies (e.g., the OTS v. the OCC) and to ensure a coordinated regulatory response to any problem. The UK FSA was a model for much of the EU and economically advanced Commonwealth nations. While there was nothing inherent about adopting a FSA that required that regulation and supervision be weak, both were pervasively weak among EU nations. Basel II was a deregulatory disaster – reducing capital requirements, relying on credit ratings, and encouraging the largest banks to determine asset values on the basis of their proprietary models. The EU's role in shaping and implementing Basel II was materially worse than the U.S.'s role, which is why bank leverage was far more extreme among EU banks. FSAs also overwhelmingly adopted “principles-based” regulation. This was viewed as being a desirable alternative to U.S. “rules-based” regulations. The asserted advantage of principles-based regulation is that rules are bureaucratic “one size fits all” approaches that dishonest firms evade through devious devices that meet the letter of the law but defeat its purpose while honest firms comply with the rules at substantial cost. If, instead, the regulator adopts reasonable principles, e.g., engage in sound underwriting then honest firms will adopt optimal underwriting procedures tailored to their needs while the regulator can take action against banks that fail to embrace the spirit of underwriting principles. That was the theory, but it bore no relationship to the reality. Most European FSAs compounded the deregulatory mistakes by embracing desupervison and decriminalization. This approach was based on four premises. It involved an explicit rejection of U.S. approaches in the 1980s and 1990s, which were derided as punitive. It was premised on the assumption that banking control fraud could not be a major problem. The allied assumption was that private market discipline was vastly more effective than regulation. The fourth premise was that “advances” in modeling, computerized underwriting, and econometrics allowed regulators to perform their (very limited) supervisory functions primarily by offsite review of data provided in regular reports filed by the banks. The anti-regulators implicitly assumed that the reports filed by banks would be accurate. Only the first premise had a factual basis. The U.S. did punish fraudulent elite bankers that committed fraud. Why this was bad public policy was never explained by the anti-regulatory proponents. The other premises were the product of intense anti-regulatory ideology arising from theoclassical economics. The UK FSA responded to the crisis by attempting to become a vigorous supervisor. It hired examiners and began to actually look at asset quality and insider abuses. The Wall Street Journal article detailed the political reaction in the UK to the FSA's effort to become an effective regulator.

“The Bank of England plans to adopt a less-intrusive approach to overseeing U.K. banks when it takes over the role of Britain's primary financial supervisor in 2012, according to people familiar with the matter. Central-bank officials in recent weeks have privately told bankers that they will no longer deploy armies of examiners to pore over banks' books and demand reams of detailed information, abandoning an approach backed by the current regulator, the Financial Services Authority. Instead, the Bank of England—which will take over the FSA's responsibilities under a new regulatory structure devised by the coalition government—intends to place a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets, these people said. The Bank of England has been telling industry executives it plans to be "less in their hair at a detailed level" and that there will be "more market discipline in the equation" by increasing the amount of information banks release publicly, said a person familiar with the matter. On its face, the shift represents an unexpected retreat from the U.K.'s recent in-your-face policing of the financial sector. It could prove controversial in a country where distrust of banks runs high following the financial crisis. But Bank of England officials believe the new tack will be more effective than the FSA's current approach and will mesh neatly with the central bank's responsibility for monetary policy and for spotting potential systemic risks before they reach critical mass. One of the first decisions by the U.K.'s coalition government, which came to power in May and is headed by the Conservative Party, was to announce the dismantling of the FSA. Starting in 2012, responsibility for supervising the financial sector will fall to a newly created unit of the Bank of England. The FSA's aggressive oversight of the industry is a recent phenomenon. Until the financial crisis hit, the agency had prided itself on regulating with a light touch, which helped lure companies to London. But the near-implosion of the U.K.'s banking system in 2007 and 2008 exposed shortcomings in the FSA's hands-off approach. While trying to reinvent the discredited agency in 2008, Chief Executive Hector Sants announced a new era of "intensive supervision" in which the FSA would proactively intervene in banks' affairs when they engaged in risky behavior. Recently, though, Bank of England officials have revealed plans for significant shifts. In a private meeting with senior industry executives late last month, a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information, according to people who attended the meeting in the central bank's imposing stone headquarters. Mr. Haldane noted that the industry finds those visits frustrating and time-consuming, and that they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data, these people said.”

The reality is the opposite of Mr. Haldane's claims. Examinations, investigations, knowledge of fraud techniques, and understanding of imprudent risks are the primary areas in which regulation can add value. The only reliable means of determining a bank's asset quality prior to disaster is detailed examination. Regulators are only “control” that can truly be independent in the face of control frauds who create a Gresham's dynamic to suborn the supposed independent controls that they hire (and fire). UK banks are not upset because examinations “rarely yield much useful information” but because they provide the most useful (and distressing) information about their losses and insider abuses. The worst UK banks are desperate to kill effective supervision. The claim that regulators are “overwhelmed” because they get data on the asset quality of a reliable sample of the banks' loan portfolios is ludicrous. Adequate sampling leads to reliable extrapolation that allows regulators to develop a sound understanding of major portfolio categories. That simplifies, not complicates, the regulators' analysis. It also provides invaluable, truly independent data to honest bankers. Ireland is a useful case study to evaluate the BOE's claims that examinations rarely provide useful information and that macroeconomic data suffice. Two reports and an article about the Irish crisis have spent considerable efforts to evaluate what went wrong with the Irish banks and their regulators. I will return to this topic in future columns. My focus here is on findings about the Irish crisis that are most relevant to the BOE's proposed return to “light touch” regulation and reliance on “private market discipline.” Klaus Regling and Max Watson authored “A Preliminary Report on the Sources of Ireland's Banking Crisis” to the government of Ireland. They are former IMF officials who have generally supported the anti-regulatory theories they now find to have failed. Regling and Watson report that Ireland's regulatory approach and results were illustrative of a failed European anti-regulatory pattern that produced: “generic weaknesses in regulation and supervision. The key issues are set out, with nuances of emphasis, in the de Larosière Report, the G-30 Report, and the UK's Turner Report, among others. The response of [Irish banking] supervisors to the build-up of risks, despite a few praiseworthy initiatives that came late in the process, was not hands-on or pre-emptive. To some degree, this was in tune with the times. The climate of regulation in advanced economies had swung towards reliance on market risk assessment. It can be accepted that the supervisory approach in Ireland reflected to some degree the climate of the times in the global supervisory community, with light-touch regulation and reliance on markets' own risk assessments.” Regling and Watson also reported that the nations that engaged in more vigorous regulation had more favorable outcomes. “[A] widely accepted lesson of the crisis is that “intrusiveness” into banks' risk management and governance had been set aside too lightly. Close and at times intrusive supervision, unlike “light touch regulation,” had the potential to identify problems earlier and in some cases prevent or mitigate their effects. Cases such as Australia and Canada are often cited in this latter category.” Regling and Watson give specific examples of where more thorough examinations could have reduced the Irish banking crisis. “Deeper inspections, however, could have been crucial as a follow-up in helping to identify and act on the scale of poor collateral, weak documentation, and low levels of borrower equity underlying some loans. Identification of poor quality loans, and the diagnosis of an undue concentration of credit risks, in the first instance requires accounting, governance and legal skills.” The former IMF officials also explain the costs of not conducting adequate examinations.

“[S]upervisors were not in a position to warn top policy-makers of the major asset risks or of some crucial problems of governance in banks, on the eve of the crisis – a failure that had very serious implications…. [M]any supervisors – faced with complex assets and operations, and with banks' ability to work around specific rules – moved to rely more on banks' own risk assessment systems and to supervise processes and principles, with some moving very far in the direction not just of “principles-based” but of “light-touch” supervision.”

Regling and Watson's first lesson that should be learned from the failure of Irish regulation emphasizes why the BOE approach is sowing the seeds for the next UK financial crisis.

“There were four main failings of [Irish] supervision: (i) The supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate for the more hands-on approach that was needed.”

Despite the triumph of anti-regulatory ideology in the U.S. and most of Europe, bank examiners persisted in finding horrific problems in the U.S. and Europe. The anti-regulators that ran the European FSAs and the U.S. financial regulatory agencies had a characteristic reaction to these examination findings. Again, Ireland illustrates the problem. When examinations are weak and supervision is premised on the naïve assumption that bank managers are all honest effective enforcement is impossible. Ireland appointed a new Governor of its Central Bank, Professor Honohan, after the crisis broke and asked him to prepare a report about the crisis. His findings on Irish regulation, supervision, and enforcement are damning.

“Prior to the financial crisis in 2008, there were no sanctions imposed on credit institutions and none that might be said to have reflected significant prudential concerns. 5.14 The financial crisis has made it clear, though, both in Ireland and elsewhere, that effective bank supervision simply cannot be performed with the thin staffing that was applied to frontline operations of the FR. [n. 88] n. 88 In the post-financial crisis world, combined with the failure of prudential regulation in Ireland, there is an emerging consensus for more intrusive prudential regulation and a greater readiness to impose regulatory sanctions. Section 5: Conclusions 4.49 The philosophy of regulation employed by the Financial Regulator was inherited from the past practice at the Central Bank. It relied on the deferential view that, as long as there was a good governance structure, decisions of the people actually running the banks could normally be trusted to keep the banks safe and sound, and their decisions did not need to be second-guessed. Voluntary compliance was the preferred enforcement strategy. The status quo: Walk softly and carry no stick”

Regling and Watson explain how these anti-regulatory approaches make Europeans susceptible to control fraud, insider abuse, and unsafe and unsound practices that can drive financial crises. Weak supervision leads to weak enforcement and weak prosecutions.

“But also, at the heart of the crisis in some of the worst-affected countries lay problems of a quite different order. [S]ome banks and other financial institutions, riding on the back of a generalised property boom, engaged in lending practices that were simply dangerous in an old-fashioned way. These were practices that did not require special supervisory imagination or moral courage to penalise. They were noted above in terms of serious failures of bank management and governance. The failure of [Irish] supervisors to act strongly against such practices is much harder to understand, and is not much mitigated by the more broadly shared issues of supervisory culture cited above. [There] were very specific and serious breaches of basic governance principles concerning identifiable transactions that went far beyond any question of poor credit assessment. The Government's notice on the nationalisation of Anglo Irish Bank, for example, refers to “unacceptable corporate governance practices” as a triggering factor in the nationalisation. Ireland was one of those cases where there were at least some instances of extremely serious breaches of corporate governance, going well beyond poor risk assessment, and eventually having a systemic impact…. The first category of failures seem to have been quite widespread - not just limited to one or two institutions. These failings concerned weak risk management, including poor credit appraisal and the overriding of internal guidelines and processes that should have prevented the build-up of such high and risky concentrations of credit risk exposure – in property generally but especially in the field of credit related to commercial real estate. More broadly there was a failure of corporate checks and balances that should have served to restrain management's enthusiasm for rapid and concentrated credit growth. This kind of weakness in governance was detected by supervisors…. [Ireland suffered from a ] straightforward property bubble, compounded by exceptional concentrations of lending for real estate – and notably commercial real estate – purposes. [The CRE bubble and exceptional concentrations] constituted a sword of Damocles hanging over the banking system. This is an area where senior management insight in the regulatory authority could have overridden systems, if needed, to prioritise the documentation of such system-wide concentrations of lending to individual or connected borrowers. Supervisors, at one level or another, were aware of most of the risks, and they did take some actions. [However,] the supervisory culture was insufficiently forceful and pre-emptive. On-site inspections were infrequent. Targeted follow-up was weak, including crucially on governance issues. Supervisors were perceived as reluctant to impose severe penalties, and during the key period when major governance problems arose, they imposed no penalties on banks at all.”

The Irish authors of the official reports on the crisis cannot bring themselves to use the “f” word – fraud, or even describe the frauds, but three Irish authors were more candid. Professors Connor, Flavin and O'Kelly authored “The U.S. and Irish Credit Crises: Their Distinctive Differences and Common Features.” (I disagree with much of their analysis of both crises, so I recommend their article to readers for an alternative view.)

“Starting in the early 1990s, the Irish government made a strategic decision to become a world-leader in “offshore” financial services. For foreign financial services firms willing to set up operations in Ireland, the main attractions were an educated, English-speaking workforce, a Western European location, and light-touch, almost nonexistent, tax and regulatory oversight. This very lax supervisory regime led The New York Times to call Ireland “the wild west of European finance.” An unintended consequence of the extremely light-touch financial regulatory regime in Ireland was to hobble Irish regulators in their oversight of domestic banks. [WKB note: it is unlikely that this consequence was unintended.] Ross (2009) … argues that the regulatory regime for domestic Irish banks during the pre-crisis period was extremely weak and ineffective. For example, for eight years, the board chairman and other directors at Anglo Irish Bank hid very large personal loans by temporarily transferring them just prior to accounting year-end to other banks complicit in the scheme, and then by pre-agreement rolling the loans back into Anglo Irish immediately after the publication of the annual accounts.” [WKB Note: Anglo Irish made approximately 180 million Euros in loans to its directors. It did not disclose this exposure. The loans overwhelmingly have not been repaid.] “Anglo Irish Bank deliberately understated its loans-to-deposits ratio through sham transactions – this took the form of agreed interbank lending by Anglo to another Irish domestic bank just before reporting yearend, and then immediately accepting the funds back from the other bank as “customer savings deposits.” In this case there is considerable evidence (obtained via media leaks) that the Irish financial regulator informally approved of the stratagem. In 2007, Anglo Irish became aware that a large shareholder was preparing to sell a 10% position in Anglo Irish shares. To prevent this share sale from impacting its share market price, Anglo senior management organized a secret circle of ten wealthy bank clients, lent each of them €30 million for the purchase of Anglo shares, with limited recourse on the loans beyond for the purchased shares as collateral. Since the loans were without recourse to the borrowers, Anglo was the at-risk investor in the shares, and was essentially using €300 million of its depositors' funds to secretly purchase its own equity shares.” [WKB note: the updated figure is that the loans totaled 451 million Euros.] “Irish Nationwide is a building society established to provide mortgages to its members. Yet it was allowed by the regulator to put its members' funds at risk by lending 80% of its funds to a small number of property developers.” [WKB note: Irish Nationwide was one of the institutions that engaged in secret transactions with Anglo Irish to hide transactions designed to benefit Anglo's controlling officials.]

The three Irish professors recognize that “moral hazard” can prompt criminal activity. Weak examination leads to inadequate records of criminal conduct and losses, which allows elites to engage in control fraud with impunity.

“Weak law enforcement was another source of moral hazard in Ireland….”

Regling and Watson emphasize that financial regulators are most effective when they are sufficiently competent, informed, independent, and courageous that they will act in exactly the opposite manner that the BOE proposes to act. Instead of deferring to (fictional) “market discipline,” the regulators add the most value when they challenge the market. The Irish banks demonstrate that rather than disciplining accounting control frauds, creditors and shareholders fund their massive growth.

“This is where regulation can, and has to, play a crucial role. That role – never an easy one for public officials to play with confidence and credibility – is to be right, against the market. Ireland's mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade, in terms of mounting systemic risk, and to head off the risks of a crisis. [There are successful regulatory] examples in other advanced economies of supervisors standing out against the crowd on one or more key issues, thus mitigating the economic and social fallout from unwise banking decisions. The over-arching lessons from the experience in Ireland fall into seven broad categories, and they are flagged here to highlight points that are explored more fully in earlier pages: In an adaptive financial system, there is a case for principles-based supervision, in conjunction with clear rules. But the “light-touch” approach to supervision has been discredited: it sent wrong signals to banks and left supervisors poorly informed about banks' management and governance, potentially impairing crisis response capacity also.”

The joke used to be that it took a generation for people to forget the lessons of a past crisis and stumble into the next one, but the BOE is so sophisticated (and its ideological blinders so opaque) that it has accelerated the process to a matter of months. Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions. Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.