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Watching your stocks?

Christopher Andrews
Continuity, Insurance and Risk Magazine 1 November 2008

Some are calling it the biggest global downturn since the Great Depression.The financial crisis is now in full swing, bringing challenges to organisations everywhere. How did it get so bad?

The financial tsunami, which had been gaining strength since the credit crunch began last summer, finally came crashing to shore in September, washing away long standing institutions and years of positive economic growth. As the great wave broke, banks went bust, economies ground to a halt, and billions of pounds, dollars and euros were pumped in to keep the entire system from being swept out to sea.

Who is to blame for all this? Had financial institutions put better risk controls in place, and financial regulators taken a more robust attitude towards policing those institutions, could all this have been avoided? Well, it certainly wouldn’t have hurt.

In terms of regulators, there is little doubt that they had their part to play in failing to prevent the financial calamities of recent months. Indeed, speaking before business leaders in Edinburgh in October, Hector Sants, the FSA’s chief executive, apologised for the regulator’s role in the situation, saying: “It is clear that a number of banks, notably those that became dependent on wholesale funding, went into the crisis with business models illequipped to survive a stress of this severity, and we did not do enough to minimise this, a fact that we regret... We are sorry that our supervision did not achieve all it should have done.”

While it is true that the FSA was quick to hold up its hands, the question still remains of why its supervision failed, and this arguably comes down to a few factors.

According to Michael Faber, vice chairman of the Institute of Operational Risk (IOR), one problem is that it didn’t possess the right skills and experience to offer a sufficiently robust supervisory process.

“In the past, regulators maybe haven’t paid sufficiently the people that join them and as a result maybe they don’t get the best of the crop, and/or they get poached into business. I suppose as a result of that, the cost of regulation and supervision is going to have to increase to allow for the upskilling of the regulator.”

This point was verified by the FSA’s chairman, Lord Turner, speaking to the FT in November when he said: “The internal audit report into Northern Rock identified that we had some fairly significant failures in our straight supervisory function. We had too much turnover. We had some people who had not been as trained as they should be and there may have been issues about whether the aggregate quality of the people there was good enough.”

As a result, said Lord Turner, the FSA would now require more people, trained more intensively, and with a clearly defined set of core skills. This up-skilling would be for existing employees, and those brought in from outside. “And in hiring some from outside, we are in some cases going to have to pay higher salaries than before and we’re not going to do supervision on the cheap.”

Peter Hahn, FME fellow in the faculty of finance at Cass Business School, sees another problem in terms of failure to invest. “One of the bigger things that’s happened in finance over the last decade is that the banks have made extensive use of technology and invested in it and turned out bigger and bigger profits, and regulators didn’t invest in the same way and didn’t have the resources and yes, that was a big problem.”

So from that disadvantaged starting point, in terms of infrastructure investment as well as manpower and people skills, the FSA was also dealing with an environment of expansion, with both businesses and government high on heady economic growth. “The attitude was that had they been too aggressive they would have been pushed back in their box. And I think that was generally the case everywhere else. I have a hard time finding any regulator that’s come out looking good in this process globally,” says Hahn.

John Tattersall, chairman of PricewaterhouseCoopers’ regulatory practice, broadly agrees with this concept, saying there has been caution on the part of some European regulators to use all of the powers available to them. “You have to have banks,” he says. “What you don’t want to do is destroy them because then there is nowhere for the citizens to save, or for entrepreneurs to borrow; so don’t spoil the party, as it were. Just wag your finger, rather than throwing the baby out with the bathwater.”

Next steps

This finger wagging policy obviously didn’t have the greatest outcome; global economic meltdown is generally considered to be unfavourable. So the question is how regulators are going to change going forward, beyond increased investment, and what likely effects this will have on industry. Also, will government now decide that this is a matter for increased regulation, rather than simply better regulating?

“I think in future there will be pressure on the regulators to provide greater oversight of what’s going on in the marketplace so they can react quicker to events that might be unfolding,” says Ed Moorby, managing consultant at PA Consulting. “Having said that, the actual need is for change in the banks, and the way they are set up, run and operate themselves because it is within some of those mechanics that things have failed.”

Moorby doesn’t believe we’ll see a fundamental change in the role of the FSA, but suspects it will want to increase its function in monitoring and controlling liquidity within banks, which would provide better transparency for what is actually going on in the market. “And they may want to play a greater role in the overall quality of the market. So we’ve seen some examples such as stopping the short selling of shares in financial institutions, and I suspect that the role of ensuring quality of the market is one that may well grow for them.”

Indeed, as Lord Turner has said, there will be changes made at the FSA in terms of pay, recruitment and training, and there is consensus that the regulator will become more robust. However, will this coincide with additional, potentially knee-jerk, legislation from government?

“There’s likely to be more legislation, and yes there’s going to be elements of knee-jerk that will cause some of that to happen,” says the IOR’s Faber. “In the past, in other countries as well, we’ve seen this, I suppose, because of embarrassment from both the government and the regulators in terms of how things have been handled.”

“I think there’s a huge risk that political issues overcome science,” says Cass’ Hahn. “And we’ve seen a lot of comments around global this and global that; every time you hear ‘global’ from a politician it means ‘don’t blame me’. The reality is that capitalism, not just banks, is going to come under more controls very shortly, this is no question, and banking is going to come under substantially more controls.”

Global Cooperation

If it is likely that increased regulation is on the horizon, surely this increases the need for the major economies’ regulators to be playing on the same field with regulations harmonised between countries. Indeed, Basel and Basel II, among others, were designed to do just that, but says PwC’s Tattersall, it’s difficult. “Regulators do things differently. Their domestic markets are different. [As a case in point] the Basel Accord was meant to have been adopted fully from the beginning of last year, but has still not been adopted by the United States, even though they were signatories to it.”

Tattersall believes there will continue to be efforts to harmonise, as well as to improve the regulation of major global institutions between regulators, but that there will not be either a single European or global financial regulator, as some have mooted, any time soon. “I probably can’t see it within my lifetime. On paper it sounds fine, but actually there are so many strong vested interests. And I think the argument I’d really put forward for that is to look at the experience of the way the credit crunch has impacted around Europe and elsewhere. Yes there has been lots of fine talking, but at the end of the day individual territories have acted from a very nationalist perspective.”

Managing risk, moving forward

From a business perspective, as companies are likely to be faced with a potentially painful triumvirate – the FSA becoming more willing and able to wield its powers, government introducing even more regulation, and an economy in recession – risk management and effective governance are returning to the fore.

Faber, for example, believes that the silo mentality in risk management will have to end to reduce disjointed views of risk exposures at the senior level. He hopes that upper management will now begin spending time within the risk management function to allow them to properly understand “some of the issues that may have been misunderstood in the past”.

“In some banks where we’ve seen problems it may be that there’s been a disconnect between the risk appetite that’s been set at board level and what’s actually happened on the ground,” says PA Consulting’s Moorby. He sites the example of banks heavily involved in structured securities, the risks of which may not have been consistent with the risk appetite set by the board.

“The risk management function needs to be more empowered, it needs to have greater visibility and needs to be able to understand what is going on on the front line of businesses much more,” says Moorby. “My sense is that what’s happened will only strengthen risk management’s hand.”

Faber also believes that risk managers should not just be focusing on loss, but should also scrutinise profit. “So for example if you start to see significant increased profit, and particularly in areas that maybe you wouldn’t expect, you need to scrutinise that. Why is it that we’re making that level of profit in that area with that trader?”

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