April 1, 2008 | posted by Michael Baxter in credit crunch |

If there is one relationship you can be sure of, it is this one.     Crisis begat the call for tighter regulation.

Banks are being blamed for the current economic crisis, and now attention is focusing on how we can ensure similar mistakes are not made again.

Yesterday, the Bank of England’s governor Mervyn King was talking in Jerusalem.

“The recent challenges presented by the latest episode of financial turmoil suggest that much hard thought will need to be given to the structure and nature of banking regulation in the future,” he said.

Then he dropped the real bombshell. “In the longer-term, it seems extremely likely that banks and other ‘near’ banks, especially those that have been regarded as similar to banks in terms of their eligibility for financial assistance, will be called upon to hold more capital and a greater quantity of liquid assets than hitherto.”

And in uttering those words, Mr King was doing what others have done before him.   In the wake of one crisis he called for a radical overhaul – but in the process has created the danger of overreaction.

In the 1930s, banking regulation in the US has been blamed by some for making the depression of that era even worse.    The Sarbanes Oxley act passed after the collapse of Enron and WorldCom is a classic example of overreaction.  It was designed to try and stop fraud, in the process it created an intolerable strait-jacket for many US companies looking to float.

Now, in calling for new regulation, there is a very real danger we will go too far.    Just before the Northern Rock debacle, Alistair Darling called for a return to traditional banking, but surely it was non-traditional banking that helped create the boom of the last ten years, and helped provide funding for new burgeoning dynamic businesses.

In the US, Treasury Secretary Harry Paulson has also done it.   

There is nothing wrong per se with Mr Paulson’s plans, and in fairness to him he first revealed his intentions to look at new regulation before the credit crunch hit the front pages.  Among other things, Mr Paulson wants the Fed to be able to examine the books at hedge funds, insurance firms and brokers, and that is a good thing.

As a former CEO and chairman of Goldman Sachs, he was never going to reveal a plan that would crush the profitability of US banks – and in some respects he is calling for less regulation, although the Fed will be given more power.

But perhaps the fundamental problems lie too deep for regulation by the Fed and the Bank of England to have an effect.

At the moment, a lot of debate relates to what’s called moral hazard, the idea that banks must be punished for their mistakes.  Well, perhaps the problem is this:  Shareholders have been punished but bank managements have not.

In the last few weeks we have heard the arguments over and over again, and it is right. Management at banks are rewarded when things go wrong, but when things fail, their rewards are still pretty good anyway.

Yesterday, Northern Rock confirmed that its former chief executive Adam Applegarth will be paid £760,000, and his annual pension is being upped by £40,000 a year to £304,000.

But maybe there is another, even-deeper, problem too.

In the US, the Fed quite simply lowered interest by far, far too much.  Alan Greenspan promoted variable rate mortgages, and a move away from mortgages that have fixed terms over the long term.

In fairness to Gordon Brown, he is a fan of fixed rate mortgages, but in the UK, the Bank of England, too, is partially guilty.

Last year, this is what Lord George said:

“At the beginning of this decade… external demand was declining and related to that, business investment was declining… We only had two alternative ways of sustaining demand and keeping the economy moving forward – one was public spending and the other was consumption.

“We knew that we were having to stimulate consumer spending. We knew we had pushed it up to levels which couldn’t possibly be sustained into the medium and long term. But for the time being, if we had not done that, the UK economy would have gone into recession just as the United States did.”

Lord George added, “My legacy to the MPC, if you like, has been ’sort that out’.”

In other words, it seems that the real roots of the current crisis lie not so much with excessive wages for bankers, or mistakes by regulators, it was because short-term economic needs were put before longer-term needs.

It is vital those mistakes are not repeated.