Creditflux Newsletter

Instead of seeing the big picture, banks and other financial players have focused on coping with over-regulation

The more detailed the rules that govern people's activities, the more they will focus on following or circumventing those rules and the less they will think about the big picture, including their own long-term interests. In other words, treat people like children and they will behave like children.

There is no better example of this basic rule of human nature than bank capital regulation. Bank capital rules are designed to ensure that banks allocate sufficient capital to their various lines of business. They spell out that, for example, they need to allocate 8% of capital to corporate bonds. But the presence of these rules has made banks obsessed with beating the system, with figuring out how to get favourable regulatory capital treatment on a particular product so they can book a profit (and ensure a bonus for employees). Today, we are seeing the disastrous consequences of that approach.

Banks have become like steroid-popping athletes. They spend their time figuring out how to take their drug of choice without getting caught, without regard to the harm they may be doing to their bodies.

Basel II is touted as an improvement on the crude original Basel Accord. In fact, because it is more prescriptive and detailed, it is far worse. As fellow columnist Wolseley pointed out last month, the whole Basel system is unfit for purpose, and should be ripped up.

Imagine, for a minute, what would have happened if Basel had not been introduced. In the pre-Basel world of the 1970s and 1980s, several countries' banks (notably Japan's) were seen as being at an unfair advantage because they employed less capital and were undercutting lending in other countries. So Basel was a protectionist attempt to impose global standards.

With no Basel Accord, the banks that bought market share and had little capital would have hit trouble. Countries that allowed their banks to be undercapitalised would have suffered a banking crisis. But now, instead of a national banking crisis in, say, Italy, we have a banking crisis in all countries at once.

The focus of bank regulation should switch to forcing greater disclosure, allowing credit and equity investors to reach their own views on how well capitalised banks are. The regulators can then read signals in the market about banks that are sailing close to the wind.

Accounting standards are another example of the corrosive effects of detailed rule-setting. The myriad international accounting regulations should be replaced by a two-line rule: tell investors everything they can reasonably expect to know in a way they can be reasonably expected to understand - or go to jail.

On a smaller scale, we can see the same rule-focused myopia in structured credit. The discount purchase rule, which inhibits the purchase by CLOs of assets trading at below about 80 cents in the dollar, is typical of the wrong-headed way the structured credit market works. Managers find a new way to screw investors, so regulators (or, in this case, quasi regulators in the form of rating agencies) impose a rule to stop them. A few years later, the rule has unintended consequences as bad - or worse - than the practice the rule was meant to prevent.

What could the rating agencies have done differently? The simple answer is that they could have demanded greater transparency from CDO managers. That way, investors would have been able to figure out which managers were trying to game the system. And, in practice, managers would have been very reluctant to put on aggressive par-building trades for fear of damaging their reputation.