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Mертон Миллер
(1923-2000)
Merton Miller
 
Источник: Economist, 7/22/95, Vol. 336 Issue 7924, p65, 3p, 1 graph, 3 cartoons, 1bw
HOOKED ON FINANCIAL RED TAPE
Successive layers of financial regulation are typically a hasty response to the latest scandal or emergency. It is time for another approach
A financial regulator's lot is rarely a happy one, as the Bank of England discovered yet again this week. Even before the publication on July 18th of an official report into the collapse of Barings, a merchant bank that went spectacularly bust in February, opposition politicians were calling for the Bank to be relieved of its supervisory responsibilities, which they want transferred to a new banking commission. In reply, Kenneth Clarke, Britain's chancellor, defended the status quo and observed that no regulatory system could prevent all chance of a failure.
Nor should it. After all, the goal of regulation is not to prevent financial firms from failing, but to ensure that, when they do, they do not undermine the soundness of the financial system. Yet after every big financial mishap, whether it involves lax internal controls, as was the case at Baririgs (see box on next page), or risky derivatives (see page 67), the pressure grows for more rules to stop the same thing happening again.
The present regulatory structure in most countries has evolved in just such a haphazard way. In America, the Glass-Steagall act, which bars banks from underwriting securities, was passed in 1933 because Congress believed that a large number of bank collapses in the early 1930s had been caused by banks' disastrous punts on the stockmarket. Deposit insurance was introduced in the same year to try to prevent runs on banks by nervous depositors. It was then vastly extended at a most inopportune moment: just before the savings and loan disaster of the early 1980s. A similar pattern is evident in Britain, where the 1979 Banking Act and the 1986 Financial Services Act were both introduced after financial scandals.
What is it about finance that makes people so keen to tie financial institutions up in red tape? There are several explanations. One is that financial transactions often involve people's savings. Another is that financial commitments are often one-off, long-term ones involving complex products such as life-insurance policies. But perhaps most important, for a modern economy to function effectively, people must have con-fidence in the financial system.
Yet even if finance is special for these reasons, it does not follow that financial markets must be heavily regulated. For regulation to be justified, there must first be evidence of market failure. In finance, the two most oft-cited cases of this are when one party to a deal is better informed than the other (known as "asymmetric information"), and when a transaction affects others not directly involved in it (an "externality").
Asymmetric information is most common in retail financial markets, where individuals who invest in, say, a mutual fund (unit trust) or pension plan are buying from firms that have both more experience and far more information than they do. As for externalities, regulators have traditionally fussed most about bank runs, in which the failure of one bank triggers the collapse of others. Given the central role that banks play in payments systems and in credit creation, such a run could cause severe economic damage. Regulation is meant to reduce this "systemic" risk.
Information gap
It is still not obvious that all this justifies detailed rules. For a start, not all buyers of financial products are innocent neophytes. Wholesale investors, such as pension funds, deal frequently in financial products; their managers are employed, moreover, because of their expertise. "There is no justification at all for regulating wholesale markets," says Merton Miller, a Nobel-prize winning economist at the University of Chicago.
The case for regulating firms that deal with retail investors is a good deal stronger. By forcing those who peddle life insurance policies and pensions to disclose as much information as possible about their wares to potential clients, regulation can reduce information asymmetries. But detailed rules that force firms, say, to decide whether the product they are selling is "suitable" for a customer can be dangerous. If individuals have enough information to make a reasoned investment decision, the only other rules that are really needed are those that protect them from fraud.
If information asymmetries can be solved largely by insisting on greater disclosure, what about systemic risk? Although there have been almost no runs on banks since the 1930s, the threat of a systemic collapse still haunts regulators--even though, as Gerald Corrigan, a former chairman of the Federal Reserve Bank of New York and now an adviser to Goldman Sachs, an American investment bank, admits: "there is no agreement amongst regulators as to the definition of systemic risk."
Mr Corrigan is, however, convinced that the threat exists. The 1987 stockmarket crash posed a systemic risk, he says, because banks and securities firms were reluctant to make payments or to deliver securities to firms that might have gone bust. He also thinks that the Barings debacle could have turned into a systemic crisis had the margin payments on the futures exchanges in question not been made in a timely fashion.
Even if one accepts this, it may still not be worth remedying a market failure by regulation, if the costs of the cure are greater than those of failure. And the present "cure" is not cheap. A recent study by the London Business School found that the direct costs of financing regulators' activities amounted to nearly 90m () a year in Britain in America the figure was .
These sums are small beer compared with the costs to firms of complying with regulations. A study by American regulators in 1992 found that, in the previous year, the country's banks had forked out between .5 billion and billion to comply with financial regulations. True, banks churn out many financial reports for their own benefit. But regulators usually demand different--and costly--versions. Different regulators may also ask for different data.
Is the money well spent? Nobody knows. To be certain, one would need to prove that the costs of systemic crises outweighed the costs of preventing them. But it is impossible to say what would have happened in the absence of regulation. Still, with financial institutions continuing to go bust with monotonous regularity, the claim that throwing money at regulation is a worthwhile exercise should at best be treated with a degree of scepticism.
Nobody is more sceptical than Professor Miller. "It is an act of faith that the benefits of regulating markets exceed the costs," he says. Worse, he thinks that many regulations may increase, rather than decrease, systemic risk. Take deposit insurance in America. By reducing the impact of failure on depositors, and by allowing banks to offer better rates in order to attract insured accounts, it provides an incentive for banks to be imprudent. Or consider Glass-Steagall. By preventing commercial banks from diversifying into investment banking, it has arguably increased their overall riskiness.
America does not have a monopoly on hare-brained regulation. Consider the 1988 Basle Accord, which forces banks in most countries to set aside capital against risk-weighted assets. Among its anomalies, the accord does not recognise offsetting risks; and, bizarrely, it considers all government bonds to be riskless. This has prompted banks to speculate more aggressively in them.
The Basle regulators' planned market-risk proposals (which require banks to set aside capital to protect their trading books against changes in interest rates) may rectify this. But in tacit recognition that the original approach was flawed, the regulators will in some cases allow banks to use their own risk-management models to determine the amount of capital that they are required to have. Many banks will simply choose the model that minimises this amount.
Ulterior motives
Benn Steil of the Royal Institute of International Affairs in London argues that most efforts to set minimum capital standards and create level playing fields are misguided. He points out that banks with insured deposits or government guarantees have an advantage over those that do not; forcing both to set aside the same amount of capital does not remove this advantage. Similarly, forcing securities firms to set aside as much capital as banks (which the European Union's capital adequacy directive will do from the beginning of 1996) is inappropriate because, unlike banks, they do not suffer from a mismatch between highly illiquid assets and liquid liabilities, and because they are not so closely connected to payment systems.
Moreover, for all the talk of level playing fields, such international deals can sometimes have protectionist rather than prudential motives. Pressure to pass the Basle Accord, for example, came from American and European bankers who claimed that "under-capitalised" Japanese banks were pinching their business unfairly. However, as Mr Steil points out, the underlying cause of the distortion was that Japanese banks are coddled by a plethora of regulations. Not one has been allowed to fail since the second world war. The result? With no incentive to act prudently, the entire Japanese banking system is now all but bankrupt.
If detailed regulation has been of questionable value in the past, it is unlikely to become more effective in the future--and may well become much more costly. There are three reasons for this. First, the pace of financial innovation over the past decade has left many regulators floundering. Most financial firms--Barings was a notable exception--have responded to fast-moving markets by improving the ways in which they manage risk. Most regulators, in contrast, still have only a rudimentary knowledge of risk management.
Second, firms are broadening the range of businesses in which they are active. Around the world, securities companies are increasingly offering banking services and banks are increasingly trading securities. This blurring of boundaries has made traditional regulatory structures based on institutional divisions outdated.
Functional regulation--ie, regulating activities rather than institutions--might be more rational because it would make it easier to keep tabs on an entire industry. But it would not prevent systemic crises. As Dirk Schoenmaker of the London School of Economics points out, it is institutions, not markets, that go bust. The solution to this particular problem might be to adopt a matrix approach, where some regulators look at a market as a whole and others are responsible for particular institutions--though this is both messy and expensive.
The third reason why regulators' jobs are becoming harder is the internationalisation of financial markets. Barings went bust, after all, because of problems not in London, but in Singapore. Andrew Large, chairman of Britain's Securities and Investments Board, wants more co-operation between regulators. "We are almost all organised on a . . . national basis . . . It can hardly be claimed we are well structured to cope," he said in a recent speech. To deal with this, regulators in different countries are belatedly trying to improve the co-ordination of their activities.
Rather than trying to come up with yet more rules, governments might do better to put their trust in more self-regulation instead, at least in wholesale financial markets. Banks and securities houses are, after all, usually quicker than most regulators to spot trouble. For instance, the Bank of Credit and Commerce International (BCCI) was treated as a pariah by most other banks long before it was closed down by regulators. And Barings' huge positions in Japanese futures contracts raised more than a few eyebrows at other banks in the weeks leading up to its demise.
Without the theoretical comfort of a regulatory net, firms would have to be more cautious. They would demand more, and better, information about the risks that their counterparties were taking and the way in which they controlled them. Scrapping rules would also increase uncertainty. Since uncertainty breeds caution, it would probably do more than any amount of regulation to limit systemic risk. So the next time that there is a financial disaster, do not call for a few more rules--but a few less.
Inset Article
BARING NOT QUITE ALL
The official report on the demise of Barings raises as many questions as it answers. That is partly because it suffers from serious shortcomings. But it is also because of the nature of the subject: as with previous bank fiascos, the chain of events was messy and hard to follow.
Discussing its shortcomings, the report lists all those who could have provided important corroboration or new evidence, but refused to do so, either for legal reasons or out of cussedness. Chief among the button-lipped was Nicholas Leeson, the trader who ran up the losses that sank the bank. Languishing in a German jail, he is unable or unwilling to account for himself. His lawyers still hope to avoid his extradition to Singapore by cutting a deal with Britain's Serious Fraud Office (SFO), but the SFO is reluctant to see Mr Leeson stand trial in London.
Crucially, the Singapore International Monetary Exchange, where much of the trading occurred, refused to co-operate. So did France's Banque Nationale de Paris, whose Japanese arm held an account with Barings' derivatives operation in Singapore. Its records might have been revealing.
But the report's biggest shortcoming goes unremarked upon by the board of banking supervision, its author. This is that the board included three senior officers of the Bank of England, the very supervisor whose role in the affair the board was investigating. It may have been one thing for Eddie George, the Bank's governor, to sit on the board; it was quite another for Brian Quinn, head of the Bank's supervision department, to be included--especially since one of his staff resigned before the report's publication, knowing that he was to be criticised for exempting Barings from normal limits on the funding of its trading activities.
The Bank's officials may thus have been naive, in granting such an exemption. But such naivety pales by comparison with that of Barings' bosses. They were puzzled that huge profits were being generated by a tiny trading offshoot in Singapore, but never asked detailed questions of Mr Leeson. They may have had their eyes so firmly set on the huge bonuses that Mr Leeson's activities were helping to rack up (see chart) that they ignored several warnings about those activities from outsiders, including a rival. The report also suggests that Barings' auditors, Coopers & Lybrand, were slow to spot defects in the firm's internal controls.
The report gives a convincing enough account of how the losses were accumulated: by a combination of deception by Mr Leeson and incompetence on the part of the bank's senior managers (although both Mr Leeson and Ron Baker, Barings' derivatives boss, have criticised this account). It also makes a disturbing analysis of Barings' legitimate derivatives operations, noting that some of its "arbitrage" activities were akin to front-running, the dubious practice of an intermediary trading for itself before executing major client business. Mr Baker's euphemistic description of this activity as "working the client information curve" deserves to enter finance's lexicon of disrepute.
Indeed, plenty of other firms should ask themselves whether a corporate push to "work the curve" might not be just the encouragement a rogue employee needs to cross the line from honesty to dishonesty. Barings' ghost has not yet been laid.
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