26 May 2015

If financial regulation kills the patient, who’s to blame?


Imagine the emotional exhilaration of the victors as the defeated Germans signed the Treaty of Versailles which ended World War One – “the war to end all wars”.  The victors’ indisputable sense of just retribution was meant to send a message for the ages.   Unfortunately, for all concerned, that age was very short.

Just a quarter of a century later, a similar coalition of victors delivered a far more enlightened verdict upon the vanquished foe, proffering reconciliation rather than reprisal.  Instead of imposing conditions that would virtually guarantee societal collapse, the Marshall Plan was designed to rebuild and interconnect shattered economies and societies.  History has thus far judged it to be the superior model of the two.

Enlightenment ultimately prevailed, but cost of achieving it was staggering.

There may be parallels as societies continue to deal with the aftermath of the financial crises.  While the immediate prospect of economic armageddon appears to have been averted, the longer term risk may lie in the (perhaps) unintended consequences of a long-tailed regulatory backlash.  Retribution, however delicious for those dispensing it, is not without its hazards.

Should the risks of proposed regulatory outcomes be assessed, and if so, by whom?   Governance failures at a number of large banks have damaged public confidence in the entire financial services sector.   But, does the industry’s diminished public image abrogate the responsibility of governments for the long-term economic consequences of regulatory processes that they themselves have created and empowered?

If regulators create conditions in which the banks’ return on equity permanently falls far short of its cost of capital, their ability to lend will be constrained.  If we want banks to be state-dominated utilities, let us at least make the choice consciously, rather than unwittingly.

When capital allocation at financial institutions ceases to be a function of market considerations, but instead is determined by political agendas, returns suffer for all commercial stakeholders.  Examples abound.  These include the Chinese State Banks, the Italian Banking Foundations the German Sparkassen, the Russian banking system, and in the UK, the Co-op.

The risk is particularly acute in Europe. In North America and much of Asia, a deeply ingrained free market ethos and various political/legal systems make it unlikely that these societies will voluntarily neuter their significant financial institutions.

Europe may yet choose to avoid the by-products of profit maximizing private sector financial institutions, and the unevenly distributed economic activity they create – but let it be the people who decide.  To think that global banks will not reduce capital allocated to a fractious Europe, populated by hostile regulators, whose most ardent free market member, the UK, is threatening to exit, is exceptionally naïve.  This risk is not limited to non-European institutions.

At the moment, HSBC is a UK bank, but may not remain one.  It is reconsidering its UK domicile, potentially opting for the stability and predictability of the (Communist) Chinese regulator, rather than subjecting itself to the vicissitudes of its UK counterpart – itself the creation of a Conservative government.  Until recently, this would have been utterly inconceivable.

The pan-European MiFID II securities legislation process may be on the brink of erecting significant non-tariff barriers in global capital markets by forcing European asset managers to needlessly withdraw from a long-established global research payment system, weakening their competitive position.

If excessive regulatory zeal does result in long-term economic damage, who will bear the brunt of this outcome – dozens of unelected regulators or hundreds of millions of European citizens?

Is there a mismatch between the will of the population and a seemingly remote and unaccountable regulatory process?    The British electorate has firmly rejected a leftist agenda, and the French electorate appears to be leaning in the same direction.  With a fresh mandate, the recently elected UK Conservative government would normally be expected to be an active participant in this process.

As the result of an emboldened and politically unconstrained “scorched earth” financial regulatory process, Europe is on the cusp of achieving a pyrrhic victory.

What manner of financial calamity or economic sclerosis will Europe have to suffer before the forces of level-headed common sense summon the courage to challenge today’s smothering Orwellian political orthodoxy and question the long-term economic consequences of potential regulatory overshoot?

How will history judge the wisdom of a European political/regulatory process that permitted anger to be the crucible in which the long-term governance framework of its vital financial services industry was forged?

Even John Maynard Keynes correctly judged the Versailles Treaty as counter-productively harsh, dubbing it “a Carthaginian Peace”.  One wonders what he would make of this.

Neil Scarth of London-based Frost Consulting works with asset managers and asset owners on regulatory issues