It seemed entirely appropriate for the world's 103 leading banks to gather in London last week during the 300th anniversary celebration of the Bank of England to ponder their collective futures. On the one hand, their traditional deposit-taking, credit-gathering franchises have been rendered nearly obsolete by the proliferation of non-banks - finance companies, insurance companies, mutual funds and others - that perform similar functions. However, most of these big bank players have adapted with remarkable agility to the aggressive new world of risk-taking, in which derivatives and other sophisticated financial products play a starring role. As Sir Dennis Weatherstone, chairman of this year's International Monetary Conference (IMC), stated in his opening remarks: 'To measure, manage and accept risk is our challenge.' The big question for banks is will regulators allow them a level playing field on which to compete?
From the regulators' point of view, the movement of the traditional deposit-takers and others into the uncharted world of derivatives is both frightening and positive. An important function of central banks is to guard against systemic risk. Yet most of their safety mechanisms are tailored to a pre-derivatives world. The huge losses generated by hedge funds send shudders through the system, and the ultra vires cases involving UK local authorities glaringly expose some of the holes. Inevitably, central bankers must ask themselves central questions: do they have enough knowledge to prevent a systemic breakdown? What happens to the system if a big non-regulated player folds? Would central banks intervene to save a huge investment bank such as Goldman Sachs, which is not under their purview?
According to Alan Greenspan, chairman of the US Federal Reserve Board, there are no solid answers. Mr Greenspan told IMC delegates that the system is now so complex that the ability of central banks to contain volatility by imposing more regulation is doubtful. He repeated his call for more sophisticated self- regulation of financial institutions, because 'government regulators can no longer do that job'. This would mean the gradual reduction of the direct supervision of risk by central banks to a role of monitoring internal risk-management systems. Implicit in Mr Greenspan's remarks is an acknowledgment that derivatives can play a positive role - distributing risk throughout the global system in a relatively controlled manner.
His remarks have become a rallying cry for traditional banks who want to be freed from the yoke of regulation to compete more effectively with investment banks, securities houses and others. Even bankers like Thomas Labrecque, Chase Manhattan's anti-regulation chairman, acknowledged that supervisory authorities must play an important role of ensuring sufficient capital, disclosure and risk identification. Even these fairly straightforward regulatory functions are now beyond the ken of central bankers.
Tommaso Padoa-Schioppa, the Banca d'Italia official who chairs the powerful Basle Committee on Banking Supervision, identified the inadequacies in what is supposed to be a fail-safe system: uneven capital adequacy requirements, a virtual 'market failure' in terms of disclosure, antiquated accounting and risk-tracking mechanisms are among them. In a world of derivatives trading, traditional banking supervisors have been left behind in terms of knowledge and understanding of the sophisticated computer modelling and financial instruments in place. Mr Padoa-Schioppa reminded his audience of the large US end- user bank that had to teach such analysts about its use of derivatives and their impact on its results in order to give them a real picture of its financial condition. His concluded that central banks have to become equally sophisticated, developing and keeping an innovative staff of computer wizards. On disclosure, Mr Padoa- Schioppa was particularly urgent. There had to be more of it to reduce the growing opaqueness of financial markets that made it hard to assess the true creditworthiness of institutions.
These issues, of course, relate to the management of a new financial system that is increasingly seamless. Traditional markets and borders have fallen, and traditional regulation is no longer adequate. Inevitably, in the words of Mr Greenspan, one common set of rules for all the big players - banks, securities houses, investment companies and the like - will have to be developed, most probably with the the Bank for International Settlements (BIS) emerging as the last bulwark. This will lead to more regulation, but of a more generic type that will create a more level global playing field.
To those who ask tough questions about whether there is more market risk and thus more systemic risk, the answer is probably 'yes'. In this environment, it is possible for a big bank to fail, a previously unthinkable development. But changing climates always present new risks. The choice is to try to turn back the clock or to allow the innovation to go forward. I vote for forward motion, but at a measurable pace.