Regulation in tomorrow's capitalism

The collapse of Enron in 2001, the largest in American corporate history, poured scrutiny over the way in which government and big business interact. As the scandal unfurled, the energy giant’s share prices tumbled from $90 per share to less than 50¢, and the financial and political fallout was stark. Aside from the Dow Jones and FTSE taking a battering for a couple of months, there were scores of red faces in politics, where the disgraced Enron had made sizeable donations to major parties on both sides of the Atlantic.

Investors and employees were stunned when it was revealed that the company’s success was founded on fictional profits, creative accounting and fraud. Total global investment exposure to the meltdown was estimated at $4bn, and further disgruntlement was directed at the auditors and regulators who failed to control these malpractices. Heads rolled at Enron’s auditors, Anderson, which was stopped from auditing public companies and ultimately folded, and the deregulated energy markets from which Enron won and lost on were reformed and tightened up significantly.

The current global credit crisis mirrors aspects of Enron on a much wider scale: the combination of unchecked risk-taking in potentially volatile markets, lack of transparency of information, and low levels of accountability and responsibility framed the conditions for the systemic failures demonstrated in the finance markets and economy in the past 18 months.

The difference between the two cases is that the UK economy was not brought down to recession by the shredding of important documents, illegal share-selling and practices which could at best be described as Machiavellian – far from it – the UK economy suffered under a system that brought financial stability and a solid economy for the best part of a decade.

So what went wrong? Explanations and scapegoats for the ‘crunch’ have got increasingly convoluted and confusing. Bankers, regulators, auditors and politicians have all taken a portion of the blame. The truth is that the whole system paved the way for our predicament: high-risk and high-level lending and borrowing, lack of regulatory powers and loose fiscal and monetary policy are just a few sound bites that begin to explain it. The long and short of it is this: capitalism dropped the ball, and it was allowed to do so. To avoid such disasters in the future, the system of financial regulation needs to be completely overhauled.

It is hard to see how the City of London had been able to be so reckless, where the Financial Services Authority has the job of enforcing a dizzyingly large amount of financial rules with its 2,800 staff. Between 2002 and today, the FSA have levied £108 million in fines for various offences. In December 2002, the Royal Bank of Scotland was fined £750,000 by the FSA for failing to carry out mandatory checks to prevent money-laundering, and within 24 hours RBS’s shares fell 43p – nearly 3 per cent. But why are fines such as this not enough to deter financial institutions from malpractice? Quite simply, the fines are not stiff enough to be a disincentive: RBS’s £750k mistake represents only 0.01% of its £6,451 million profit for 2002.

Besides its lack of power, the FSA alone is not an appropriate institution to address the mess. Whether or not we believe Lord Turner’s view – that the FSA were pressured into ‘light touch’ regulation by the politicians – is of less significance: the regulator did not react to warning signals from Northern Rock and allowed the bank to operate without risk mitigation months before the bank’s collapse. The FSA acknowledged it failures, albeit conditionally, but the politics of regulation is too cheap an excuse for errors of the magnitude that have been witnessed.

Policy makers have been slow to acknowledge both the impact of the crisis, and the need to restructure the institutions that allowed it to happen. The G20 economic summit last week finally addressed the question, ‘we’re here now, so what are we going to do about it?’ Aside from the shorter term solutions of substantial fiscal stimulus, the summit unveiled a number of new measures that look to address dodgy practices in finance.

These include banks being forced to hold more capital during boom, upping the scrutiny and effectiveness of ratings agencies, setting up a central clearing house for derivatives, changes to the awarding of bonuses and, of course, sharpening the tools of the financial regulators. Far from being a hindrance, these measures will serve the financial industry as much as they do financial stability as a whole, especially in the long run.

Bankers’ bonuses must relate to the risks they are taking – big bonuses for high risk trading cannot continue; credit derivative trades (which sent Lehman Brothers under, sending shocks through markets globally) will now be carefully controlled through the central clearing house; The Financial Stability Forum, which has been in existence for ten years, has been given much more muscle and will now act as a global super-regulator which currently includes 20 countries, and will work with the IMF to spot looming financial disasters.

All of these measures seek to address aspects that have been missing from western financial systems: transparency, accountability and responsibility. Voices which still advocate the reign of the unchecked market in this debate have got increasingly softer. Critics of increased regulation believe that it will simply create rules which banks will find new ways to meet while still operating irresponsibly. Similar free market rhetoric undercuts this argument: as long as incentives for compliance/disincentives for violation of the rules are strong enough, then we begin to see an operable system.

Besides these points, debate has moved on from free markets vs. regulation as the way forward: in reality the possible solution is not polarised between the two. Competition can still thrive with rules – the public sector is not looking to encroach on the markets any more than necessary to create conditions for sustainable competition and economic growth. The UK does not have to fear the City being uncompetitive as a result of stricter rules, as the subscription to change has been international where most leaders at the G20 recognise the interconnected nature of economies and see the advantages of enhanced policy cooperation.

The system of corporate governance is undergoing essential changes, and as Peter Larsen succinctly puts it: “The global financial system as we know it was forged by deregulation underpinned by belief in free markets. That approach failed. The task now is to prove it can be set running again with better brakes and better steering.”