Don’t put your faith in regulation

Well, at the time of writing, here we are in the middle of worldwide financial chaos with major banks in disarray. Ironically, it has always been considered that banks were ahead of the game so far as risk management was concerned, and they have been subjected to more regulation than probably any other sector. So what went wrong?

From a European perspective, it seems that Basel I and II have had little to say on liquidity risk management. In a classic ‘too little too late’ move, as the banks started to crumble in February, the Basel Committee on Banking Supervision’s Working Group on Liquidity released a paper entitled Liquidity Risk: Management and Supervisory Challenges, which highlighted financial market developments that affect liquidity risk management and discussed national supervisory regimes and their components. Thank you, guys, very helpful, just wish you had thought of it sooner.

In any event, banks doing ‘good’ liquidity risk management were impeded by the development of deals which sliced and diced transactions passed around the market in such a way that it was difficult to calculate exposures.

This may sound familiar to insurers. The retro insurance debacle of a few years ago has some clear parallels – people passing on and accepting packages of risk without any idea what they were taking on and how it would affect their accumulations. An underwriter from those days told me, ‘Every time there was a major loss, we used to wonder if we were involved – no-one knew.’ This is a sentiment that is hideously familiar to some of the banks in trouble today.

One of the main questions that has come out of all this is – where were the regulators? We don’t expect regulators to tell companies how to run their businesses but we do expect them to ask pertinent questions.

Back in February, in connection with the Société Générale alleged rogue trading debacle, I wrote: ‘Knowing that you comply with strict regulatory rules and have all the systems in place breeds complacency. And that can produce a false sense of security.’

Regulators are not invincible – they may not even be that efficient. And regulations merely set minimum guidelines. Unfortunately, but inevitably, we are going to see some ‘sticking plaster’ regulation hurried through by many countries. Let us hope compliance does not cost as much as Sarbanes-Oxley did.