Jeremy Warner's Outlook: Bankers beware. Regulators are back in the saddle

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The Independent Online

Worried about losing your job in banking? No matter. There are lots of them to be had in financial regulation. So says Adair Turner, the new chairman at the Financial Services Authority. One of the problems with the FSA, he says in declaring an end to "light touch" regulation, is that there are too few regulators and because they are not paid competitively, the best ones are easily poached by the firms they are meant to be regulating.

All that's about to change, he has said in a couple of newspaper interviews published yesterday. Quite who is going to pay for the increase in budget demanded goes unanswered. The City watchdog is funded via a levy on the firms it regulates. The way things are going, there will soon be nobody left to supervise, let alone pay the regulators' wages.

Lord Turner of Ecchinswell is new to the job, and in current circumstances you would expect him to send out some clear messages about the need for tougher regulation. Whether that also requires a bigger budget is a different issue. Yet in any case, it all seems a bit late now. The horse has well and truly bolted, and for the time being, it doesn't actually require tougher regulation to rein the old nag back in again. That purpose is already being achieved with great effect by markets.

The FSA boss asks for more money, yet where was the FSA when it was really needed in the run-up to this all-embracing crisis? As recently as a couple of weeks back, Hector Sants, the FSA's chief executive, insisted that all British banks were perfectly solvent, as indeed the FSA had been doing for years. A week later, he was forcing the British banking system to take £37bn of taxpayers' money to shore up shot-to-pieces confidence in bank balance sheets. What looks solvent in the good times rapidly becomes insolvent in the bad. The FSA failed to appreciate this self-evident truism until it was too late, yet now it asks for more money.

The banking crisis is one of liquidity – inability to find the cash to meet commitments – and solvency, which is a different, but related, problem that occurs when assets become impaired by bad debt experience to below the value of the liabilities. If investors, lenders and depositors start to believe there is a solvency problem, they won't lend to the banks involved, confidence goes, there's a run, the liquidity pool runs out, and the bank is essentially bust whether or not it is actually insolvent.

Few foresaw the extent of the present crisis, if only because there is no recent experience of it. In that regard, the FSA is no more guilty than anyone else. What's more, the Government encouraged the FSA's light touch, non-intrusive approach. The City seemed to be a pure money-making machine, and the public finances grew rich on the back of it, along with everyone else. The attitude was: if it ain't broke, why fix it?

On the other hand, it is the FSA's job to ensure that banks are sound, and self evidently, they weren't. It is not at all clear that this regulatory failing – which was more a case of failure in judgement and approach than lack of resource – is going to be addressed by having a lot more highly paid regulators. To the contrary, this will only make what to many non-offending firms is an already ruinously costly paraphenalia of regulation more burdensome still.

The present banking crisis seems unique, and maybe in terms of its size and contagion, it is. But it also con-forms to the pattern of banking crises down the ages where there is a major expansion of credit, a consequent collapse in lending standards and a subsequent surge in bad debts.

The time to have had more effective regulation was when the credit bubble was still building. Bankers are so chastened by the events of the past year that you could now remove all regulation and still they would keep to the straight and narrow. It's going to take years for the debt overhang created by the last boom to work its way out of the system.

There is, nonetheless, a certain inevitability about the thunder of regulatory hooves now descending on the City. The use of public money requires a much higher degree of public accountability. The moment bankers admitted they needed to be bailed out, they opened the floodgates to those that would regulate away all risk-taking. But, to be fair, more regulation is not just the quid pro quo for public money. The existence of such a public safety net creates moral hazard. Bankers who believe they will never be allowed to go bust are more likely to take risks. Regulation has to step into the breach to ensure that this does not occur.

Yet though we may need more effective regulation, we don't need bigger regulation and we certainly don't need the sort of regulation that stifles wealth creation. In broad terms, the solution is not that complicated. The greater the risk, the more capital bankers and financiers should be required to set against it.

This doesn't necessarily require more and better-paid regulators. Whatever is done to address the problems of the past is unlikely to anticipate the pitfalls of the future. We can constrain our own domestic banking system if we like, but in an interconnected world, that's not going to stop the financial wizards creating mischief from offshore centres and far away places.

Lord Turner is an intellectual who understands better than any the need to get the balance right. The City is not going to be the money-making machine it once was for a long time to come, but the last thing Britain should be doing is undermining what was until recently the country's most successful industry. Excessive regulation is not the answer, tempting though it might be permanently to cage the wicked bankers.

However well paid and clever the regulators, financial markets will always be one step ahead, and come the next boom, the flat foots won't be able to keep up. But that's not to say all attempts to regulate markets are essentially futile. Consideration should be given to reintroduction of Glass-Steagall type regulation, which enforced a rigid separation between commercial and investment banking. If you give a bonus-driven investment banker a big balance sheet to play with, it's asking for trouble. Restrict investment banking to its legitimate purpose of capital raising, advice and transactional services for clients and it's much less of a problem. Certainly, such structural regulation would obviate the need for hundreds of regulators to be pawing all over every product innovation, hopelessly trying to assess its risks for capital and bonus purposes. That way madness lies.

As I say. There is no point in regulators trying to keep up with markets. Money finds a hole and makes trouble. The trick is to keep the herd broadly moving in a safe direction. This is best achieved by building walls between different parts of the financial system and, of course, by having decent, counter-cyclical macro-economic policy.

Even then, we will never entirely eradicate financial crises. The really bad ones operate to a 30- to 40-year cycle, which is about the time it takes for all institutional knowledge, among bankers and regulators, of the last one to be forgotten. Once the newer generation is established, the cry goes up "things are different this time" and it's let rip all over again.

Ministers insist that the partial nationalisation of banks is a temp-orary solution required by the severity of the crisis and the much larger economic cost that would be imposed if the banking system were allowed to fail. As soon as confidence is restored, the banks will be privatised again. In that sense, what's happening is said to be quite unlike the nationalisations of the immediate post-war period, where the intention was to put the politicians in charge of the commanding heights of the economy.

Yet already there are plenty of signs of political interference. Curbs on pay and dividends don't seem so unreasonable. Ministerial approval of directors, and direct interference in the process of credit allocation, are much more concerning. The Government has already moved well beyond the confines of a normal, commercial investor.

Markets obviously need to be better regulated and made more publicly accountable. But there is a world of a difference between these entirely laudable aims and the return of "big government" that some have been enthusiastically declaring. As China strives to adopt our capitalist ways, we may, ironically, already be passing them going in the opposite direction. Let's not throw the baby out with the bath water. Better, more effective regulation, certainly. But bigger regulation? I doubt that's going to help us very much.