Placing more burden back on banks


Comment:Regulation in Ireland is now widespread and reflects the fact that producers will try to exploit consumers at every opportunity - so much for ethics in business and codes of conduct, writes  Michael Casey.

Given the rate at which regulatory bodies are being set up we will soon have two economies: one that produces goods and services for consumers and a second one that supervises the first.

Industry regulation is an expensive business; most of it is paid for by the taxpayer and it is important to ensure that it provides value for money. Regulation of monopolies (public or private) is necessary because a firm with market dominance can easily exploit its customers. The need for regulation is less clear-cut where competition exists. If there is competition between financial institutions, for example, why bother to regulate them?

Presumably, one reason is that the complex information regarding financial services can be manipulated easily by the providers of these services. Maybe, deep down, there is a recognition that competition among financial institutions is not all that it could be.

Apart from consumer protection, the main reason financial institutions are regulated seems to be a desire to prevent them from going bankrupt. This is essentially what is meant by prudential regulation, but why should we care if a bank or a building society goes out of business? Firms go out of business all the time and the resources are rechannelled into more productive activities; this is how economic development works. Why are banks different?

The conventional argument is that a bank failure can cause damage to other financial institutions (the contagion effect) and ultimately damage the economy. Fairly recent Scandinavian and Japanese experience provide some evidence for this - and this experience certainly galvanised the BIS and the IMF in the direction of even more widespread prudential regulation. Arguably, this was an overreaction; when things go wrong bureaucracies typically resort to more regulation.

There is, however, no evidence that even the best regulatory system in the world can prevent a bank from getting into difficulty. Why, in any case, would we expect civil servants to know more about commercial banking than the staff of the institution being inspected?

So, our belief in prudential regulation is very much an act of faith. At the moment it is a strongly held belief, but in 10 years, the theology could be quite different and much more laissez-faire. The regulatory apparatus will probably be wound down over the next decade. (Does anyone now remember exchange controls and the high costs they imposed on society?)

Historically, central banks did not pay much attention to the consumer; prudential regulation was the only game in town. If the banks made handsome profits at the expense of the consumer that was all to the good; it lessened the possibility of bankruptcy. Indeed, large profits seemed to indicate that the bank in question was efficient. It was only economists who argued that super-normal profits could reflect monopolistic power rather than efficiency and good management.

Thankfully, following legislation, there is now more emphasis on the consumer and the old-time religion has receded if not quite disappeared. Economists may also have been right (awful thought) when they argued that what was good for the consumer was good for the efficiency of the business concerned, and, ultimately good for the economy as a whole.

Even if, as suggested above, prudential regulation will tend to shrink over time, it would still be desirable to shift the focus even more towards principles-based regulation. Putting it starkly, there would be less need for detailed and time-consuming on- site inspections if tougher sanctions were laid down for breaches of the "principles".

Would any institution ignore its capital adequacy requirements or overcharge customers systematically if the penalty were equivalent to a 10th of its annual profits, say?

Such a sanction would of course upset shareholders so much that offending executives would be dismissed - quite unlike the present set- up. Under such a tougher regime, senior bankers would at last earn their pay, the institutions would become more efficient and consumer-friendly and the costs of regulation would fall. Society as a whole would benefit.

Part of the problem with prudential regulation is the assumption that at the end of the day if things go wrong, a bank would be bailed out by the Financial Regulator. This assumption is widely held because the Central Bank is the lender of last resort and because the Financial Regulator, as supervisor, would have to take some responsibility for the failure. This results in the familiar problem of "moral hazard", ie knowledge that there would be a bail-out gives rise to complacency about how the supervised entity is run.

It would be desirable for the Financial Regulator to eliminate any vestige of moral hazard by making it clear to the lending institutions that there would be no question of a bail- out, especially one using tax-payers' money.

In other words, in the event of a failure (however hypothetical that might be), the shareholders would have to take the hit and they in turn would demand redress from the bank's executives. This would make the institutions concentrate much more on the risks they are presently incurring and, from a prudential point of view, would be worth a hundred exercises in stress-testing.

Placing more of the burden back on the banks themselves - where it belongs - is clearly desirable. All entrepreneurs have to take responsibility for their own actions. Why should banks be any different?

Making the banks concentrate more on the risks inherent in their lending is all the more important since the Central Bank cannot adjust interest rates and has not engaged in moral persuasion in an attempt to moderate lending. Since a large part of the Financial Regulator's new mandate is to protect consumers, it could hardly countenance tax-payers' money being put in jeopardy.

It is unlikely that any minister for finance would have a difficulty with making a clear statement about the non-availability of tax-payers' money in (the hypothetical) event of a bank failure, since the banks have hardly endeared themselves with the public in recent years.

With a tougher regime, more appropriate penalties, and the elimination of moral hazard and complacency, prudential regulation can be slimmed down and made more efficient in the sense of improved social outcomes at lower cost.