Don't expect the regulators to prevent these frauds

Financial View
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The Independent Online
A month without another financial crisis in the banking or securities markets is a rare event. Each time, it leads to demands for new controls, greater supervision and often for some new international body to oversee this or that market in the hope of preventing a repetition.

The Group of Seven industrialised countries reflected this determination to stay ahead of scandals such as Barings and Sumitomo by discussing ways to improve supervision of financial markets at the summit in Lyons last week.

Britain put forward a plan which gives a single regulator responsibility for co-ordinating international action if a multinational firm runs into trouble. "The idea is to make sure that something doesn't fall through the cracks," said one British official.

But the contrary view is gaining ground that there is too much concentration on detailed supervision, and too little reliance on market mechanisms to prevent disasters.

That line of argument is backed up by the fact that while there there have been many of these disasters over the last 20 years, the real risks they bring to the financial system are actually much less than they appear.

Just as it needs a large number of road accidents to produce a reliable indication of the risks of driving, the majority of financial accidents have turned out to be minor collisions.

Even the equivalent of motorway pile-ups - the US Savings and Loans crisis, the Japanese banking losses and Mexico's financial crises - have been contained, and have certainly not brought the system down.

By far the commonest theme running through recent disasters is fraud, the cause of most of the individual bank and trading company losses.

Sometimes fraud starts with outright theft on a grand scale, as at BCCI, the corrupt bank founded by Aga Hassan Abedi, or at Banco Ambrosiano, the Vatican bank that collapsed in 1981 after its boss, Roberto Calvi, was found hanged under Blackfriars Bridge. More commonly, it is a result of individuals gambling with their employers' money and getting in deeper to cover their losses, as Nick Leeson did at Barings and Yasuo Hamanaka may have done at Sumitomo.

There is also a suspicion that Mr Hamanaka was able to operate the frauds that lost the company so much money only because senior management approved of his broader strategies for rigging prices in the copper market over a long period.

The most important practical lesson from these frauds is that they are about as preventable as a lightning strike and to ask supervisors to stop them happening is a waste of breath.

The frauds have thrown up several lessons, such as the need for banking and securities regulators in different markets to talk to each other more often. Poor liaison between Singapore and London was a feature of the Barings affair and similar difficulties between Japan, New York and London occurred with Sumitomo.

But these are contributory factors, delaying discovery, perhaps only by a matter of weeks in the Barings case, and they are certainly not the causes. Supervisors inevitably trail a long way behind innovative criminals, and as a result are largely impotent in dealing with frauds.

Another area where the supervisors' impact is much exaggerated is where large losses result from shocks to the financial system. These cases are often muddled with frauds, because they produce, as a side effect, fertile conditions for crooks.

The myth about the US Savings & Loans debacle in the 1980s was that it was a massive fraud on the American public using taxpayer-guaranteed deposits. In fact, it was a combination of a speculative bubble with badly thought out and over-hasty deregulation of the savings industry.

The equally spectacular difficulties of the Japanese banking system over the last five years have been a hangover from an enormous speculative binge in the late 1980s. It is hard to see how supervision of the banking and securities markets can deal effectively with the powerful forces at work in these cases.

Indeed, it is a rare disaster where market regulators take the lion's share of the blame. Lloyd's of London may be a candidate for this doubtful honour.

But whether or not they can be blamed for individual incidents, the most serious charge made against bank and securities supervisors is that the more vigorously they do their jobs, the less banks, securities firms and their customers bother to do their own independent checks.

This much debated problem came to the fore most recently in the rescue of Mexico, orchestrated by the US Treasury, which feared horrible consequences for the world financial system if investors were not bailed out with a large international loan.

The Bundesbank was among those who doubted the wisdom of the rescue. It reflected the more sceptical view that rescues give investors a false sense of security. They undermine the incentive for other players in the marketplace to check out the performance of a company or a country before they put their money into it.

Mexico has had three crises in 15 years, and each time investors have ploughed money, happy in the knowledge that it is effectively underwritten by the US Treasury and the International Monetary Fund.

Even the Bank for International Settlements, which represents central bankers, has shifted away from the view that more supervision and regulation is the answer to every problem in the financial markets. Its last annual report urged ''clearer signals from the authorities that the fate of financial institutions rests primarily in their own hands".

The idea that intensive and detailed supervision of the markets can be counter-productive is not a new one. Indeed, New Zealand has begun to put it into practice by cutting back on bank supervision and switching the emphasis of banking controls to disclosure.

If there is no market watchdog whose presence reassures investors that everything is all right, customers are forced to make proper assessments of the soundness of banks. If they have not got the resources themselves, they can use credit rating agencies. If investors get it wrong, it is their own fault.

New Zealand is hardly a big player in international markets, but the wind is beginning to blow its way. For example, international securities supervisors have given up hopes of setting out detailed regulation of the derivatives markets and have opted instead for greater disclosure, combined with attempts to check that banks' internal controls are adequate.

The supervisors themselves have also realised there is no point in pretending to be able to prevent problems that are outside their control. If they do, they get it in the neck when things go wrong.

There is a growing view that the best way to cope is not to keep writing new rulebooks but to give more responsibility to the markets, which have turned out to be pretty good at handling defaults and crises.

The corollary is that more firms in trouble will be allowed to fail, to drive home the lesson to international investors that they, not the supervisors, are the last line of defence.