Journal of International Banking and Financial Law January 2009 3

Spotlight
How well-meaning accounting and
legal principles contributed to the
financial crisis
KEY POINTS
The regulators’ mantra of risk-sensitivity has meant in effect that regulatory
capital was more sensitive to the market price of risks, which inevitably led to
systemic crisis. Mark-to-market accounting was one, but not the only source
of increased sensitivity to market risks. The legal principle that we must
preserve equality of treatment of financial institutions has contributed to the
systemic fragility of the banking system. There is natural diversity in a
financial system and it is a key source of liquidity that should not be
destroyed. At the time of the first banking crash, 400 years or so ago, it was
reasonable to blame the bankers. After the 85th banking crisis you have to
ask: where was policy? Avinash Persaud’s solutions to banking regulation are
as simple as they are radical.

Everything that happened in the 2007 crash was a direct result of the
incentives provided by banking regulation. The crash was a failure of
regulatory policy. More damning, it was an inevitable failure, a predictable
failure and an avoidable one.

Behind this failure was a set of principles, some of them accounting and legal
principles, that appeared sensible, but were systemically dangerous and
proved so. It is of course important to remember that while regulators ignored
more warnings than they should have, we are all fallible. They may have
behaved as if captured by the large financial institutions, but they are
generally well meaning and underpaid and often operating under great stress
and time pressure. They adopted wrong principles and arrived at a system of
banking regulation that was fatally flawed twice over – but there were also
mitigating circumstances.

During much of the time since the mid-1970s, and often for sound reasons,
‘government’ has been in retreat and ‘markets’ in the ascendancy. We no
longer walk on the moon. The commanding heights have been brought down
to earth, privatised and regulated. Markets have evolved from the ghetto to
the keeper of truth and bringer of discipline. In this context, accountants
adopted mark-to-market accounting and bank regulators put market prices at
the centre of banking regulation.

Regulators today hide behind the fig leaf that Basel II had only been in force
for a couple of years. But Basel II was not an overnight revolution, but an
evolution. Its protagonists proclaim that its main point of departure from the
past is that it is a risk-based system, but this approach was adopted into
Basel I, with respect to market risk, in 1995/96. Basel II is a statement of the
latest evolution of thinking on banking regulation.

At a general level, perhaps articulated more formally in the third of the three
pillars of Basel II, banks are supposed to expose themselves to the discipline
of market prices through stock listings and adhering to strong disclosure and
transparency requirements. In Pillar I, market prices feed into the valuation of
assets, through mark-to-market accounting and through measures of the risk
of assets, either through supervisory-approved internal risk models, that use
market prices as a key component, or external credit ratings. While credit
ratings are not as volatile as market prices, they do mirror the trends of
market prices. Credit upgrades follow rising credit prices and credit
downgrades follow falling credit prices. The regulators mantra of risk-
sensitivity has meant in effect, if not in intent, that regulatory capital is more
sensitive to the market price of risks.

Regulators did not object to this development; they encouraged it. The greater
reliance on market prices was considered to be modern and sophisticated and
would provide a bulwark against the manipulation of bankers. Unlike
predetermined buckets of risk, market prices were continuous over time,
across a wide schedule of assets and responsive to new unforeseen events
and products. Regulators boasted that their attempt to be more risk sensitive
was helping regulatory capital converge to the economic capital that a well-
run bank would carry anyway.

The reason why we regulate banks over and above the way we regulate any
other business is that markets fail and when they do so the consequences
can be systemic and substantial. Consequently, market prices cannot be a
defence against market failure. Cannot be and was not. By relying on market
prices in the control of risks, the response of the banking system to a boom
would be to accelerate lending further. In the boom, profit margins in banking
shrink as more players enter into the market. Asset prices rise and the market
price of risk falls, strengthening bank balance sheets. The natural response of
banks will be to return to previous margins by increasing the leverage of
assets that appear safer. Indeed, those banks that do not restore margins are
viewed by the stock markets as inefficient users of capital and are punished.
This is what Citigroup CEO, Chuck Prince, meant when he said to the FT,
fatally for his own employment prospects, on 9 July 2008. ‘When the music
stops, in terms of liquidity, things will be complicated. But as long as the music
is playing, you’ve got to get up and dance.’ Mr Prince was chastised for
making this apparently reckless statement at the eleventh hour, but it was no
more than an apt description of the reality of market discipline. It is why the
banking casualties in this crisis, like Northern Rock, Bear Sterns and Lehman
Brothers, generally enjoyed a higher P/E rating from the stock market just six
months before the crisis than the survivors like HSBC, Bank of America or
JPMorgan.
The process is even uglier in reverse. As market prices fall and price
measures of risk rise, banks appear to have less capital set aside against
risky assets than they thought they had, and so they need to sell some of
these assets to restore their capital ratios. Because each bank is responding
to external market prices, they end up selling assets at the same time and so
they further depress asset prices and inflate measured risk, reducing capital
and causing further sales and so on in an accelerated manner until capital
vanishes down a liquidity black hole. More market discipline anyone?

Regulation was from the onset inadequate in scope. Even if regulations were
counter to the trend in market prices, it would never be an objective for
regulatory capital to converge with the economic capital that a good bank
would put aside on its own accord. The point of regulating banks differently
from other sectors is that they are systemic. When your high street shoe shop
fails, other shoe shops benefit. When your high street bank fails, the system is
in peril. Systemic risks mean that the social costs of failure outstrip the private
costs and so even well run banks will always under-invest in avoiding failure
from the perspective of the large social costs that will be incurred by their
failure. Banking regulation fails from the onset if its goal is merely to get every
bank to follow the best banks.

The solution to this is as straight forward as it is radical. Banking regulation

assumes that systemic collapses stem from one random bank failure. Instead,
crashes always follow booms. The economic cycle is the principal source of
systemic risk. Professor Charles Goodhart of the LSE and I have proposed
counter-cyclical capital charges that would run against the pro-cyclicality of
market prices. We propose to multiply the capital a bank is required to put
aside against its assessment of the risk of its assets, by a factor that relates to
the growth of a bank’s asset values.

In conjunction with the central bank, the regulators will set a maximum and
minimum threshold for bank asset growth. Growth within this threshold would
be consistent with the central bank’s inflation target, thereby linking the macro
prudential with the micro prudential. Lending growth above the maximum
threshold will lead to greater capital requirements, and growth below the lower
threshold will lead to lower capital requirements. There will be a number of
implementation issues, such as how not to penalise new and small banks or
how to deal with a bank that operates in several countries with
desynchronised economic cycles, but these are surmountable issues that can
probably be dealt with without significantly increasing the three hundred
pages of Basle II and the thousands of pages of Appendices and
explanations.
Whenever proposals are made to reform bank regulation, bank lawyers leap
out to say that we must preserve equality of treatment. This is a fine legal
principle, but it has contributed to systemic fragility of the banking system. If
two financial institutions hold the same assets, one, smaller institution, funds
that asset with 12-month fixed-rate, fixed-term deposits and the other, a larger
bank, by borrowing overnight in the wholesale money markets, financial
regulators treat both the same because they both have the same asset. Yet,
the bank that is able to fund in the wholesale money market, may have
greater access to liquidity in the good times, but is engaged in a far riskier
activity from a systemic point of view.

The equality of treatment principle has contributed to the false idea that risk is
inherent in instruments and risky instruments should be treated the same way,
whoever is holding them. This idea is commercially advantageous to big
banks seeking to use their size to help them dominate a wide range of fi
nancial businesses. But risk is in fact inherent in behaviour. Different
behaviour needs to be treated differently. Systemic risk is minimised when a
financial system has risk absorbers who, as a result of their long-term
liabilities (a pension fund would be an extreme example) or long-term funding
(such as equity investors, long-term bond financing, or locked-up investors),
have a natural ability to diversify risks across time.

However, if these institutions are forced to value and assess risk using short-
term price measures on the basis of common standards and equal treatment,
they will not be able to diversify across time, but will have to react with
everyone else to short-term price movements that have little economic
relevance to them. Moreover, if there is no reward to funding assets over the
long-term, there will be a tendency for a systemically dangerous reliance on
short-term funding. Remember, this crisis did not evolve as a result of a
significant rise in defaults across credit markets, but as a result of the
disappearance of funding markets.

Financial market liquidity requires diversity. When institutions funded

overnight are forced to sell assets as current prices fall, long-term funded
institutions that can diversify over time should be buyers of these same
assets, containing market falls. Rules that treat all institutions the same lead
to all firms selling or buying at the same time and creates systemic fragility. I
have proposed that in assessing the amount of capital to be set aside for
holding risky assets, we need to consider not the risk of the asset, but the risk
of the combination of the asset (or pools of assets) and its funding (or
assigned pools of funding). The greater the liquidity mis-match the higher the
capital required. This would incentivise market participants to seek long-term
funding and would encourage those with long-term funding to play a
systemically important stabilising role.

This would be made even more possible if we also switch from a mark-to-
market accounting standard to a mark-to-funding one. The lesson of this crisis
is not that we need more or less regulation, but that we need better regulation,
more attuned to the market failures we are trying to correct.

"Rules that treat all institutions the same lead to

all firms selling or buying at the same time and
creates systemic fragility."

Spotlight
Biog box
After 20 years in the City of London as a senior executive at JPMorgan, UBS
and State Street, Avinash Persaud has become a senior financial and
economic adviser to institutional investors and policy makers. He is co-chair of
the OECD EmNet and in 2008 he was appointed to the UN High Level
Commission to propose reforms to the international financial system. Persaud
won the Jacques de Larosiere Award in Global Finance in 2000 for warning
that the current approach to risk management embedded in banking
regulation was making the financial system less safe.