The Bank of England Sows the Seeds of the Next UK Crisis

This column is the third in a series of discussions of the developing EU crisis inspired by discussions at the recent Kilkenomics Festival in Kilkenny, Ireland. This installment addresses two recurrent and related myths that are the enemy of effective financial regulation.

? Control fraud by financial institutions can be ignored
? Bank examiners and bank underwriting add little value and can largely be displaced by software

This column warns of a disastrous desupervisory development by the Bank of England (BOE). The inspiration for this column (as with last week's column on silver bullet solutions to the Irish crisis) is Richard Field. Mr. Field has cheered the BOE's planned desupervision as implementing "21st Century Oversight." This column also draws on the lessons that should be learned from Ireland's failed experiment with desupervision.

The Wall Street Journal reported on November 17, 2010 that the BOE was junking the Financial Services Agency's (FSA) "intrusive" bank examinations and substituting off site data reviews. A bit of regulatory background is required to understand the issues. The UK's FSA was supposed to be 21st Century Oversight model. The concept of the FSA was to bring together all the relevant financial regulatory authority in a single agency in order to avoid "competitions in laxity" among rival agencies (e.g., the OTS v. the OCC) and to ensure a coordinated regulatory response to any problem. The UK FSA was a model for much of the EU and economically advanced Commonwealth nations.
While there was nothing inherent about adopting a FSA that required that regulation and supervision be weak, both were pervasively weak among EU nations. Basel II was a deregulatory disaster - reducing capital requirements, relying on credit ratings, and encouraging the largest banks to determine asset values on the basis of their proprietary models. The EU's role in shaping and implementing Basel II was materially worse than the U.S.'s role, which is why bank leverage was far more extreme among EU banks.

FSAs also overwhelmingly adopted "principles-based" regulation. This was viewed as being a desirable alternative to U.S. "rules-based" regulations. The asserted advantage of principles-based regulation is that rules are bureaucratic "one size fits all" approaches that dishonest firms evade through devious devices that meet the letter of the law but defeat its purpose while honest firms comply with the rules at substantial cost. If, instead, the regulator adopts reasonable principles, e.g., engage in sound underwriting then honest firms will adopt optimal underwriting procedures tailored to their needs while the regulator can take action against banks that fail to embrace the spirit of underwriting principles. That was the theory, but it bore no relationship to the reality.

Most European FSAs compounded the deregulatory mistakes by embracing desupervison and decriminalization. This approach was based on four premises. It involved an explicit rejection of U.S. approaches in the 1980s and 1990s, which were derided as punitive. It was premised on the assumption that banking control fraud could not be a major problem. The allied assumption was that private market discipline was vastly more effective than regulation. The fourth premise was that "advances" in modeling, computerized underwriting, and econometrics allowed regulators to perform their (very limited) supervisory functions primarily by offsite review of data provided in regular reports filed by the banks. The anti-regulators implicitly assumed that the reports filed by banks would be accurate.

Only the first premise had a factual basis. The U.S. did punish fraudulent elite bankers that committed fraud. Why this was bad public policy was never explained by the anti-regulatory proponents. The other premises were the product of intense anti-regulatory ideology arising from theoclassical economics.