New rules of engagement for banks and regulators

A feature I wrote for The Financial Times 01/05/11 on how banks manage their relationships with regulators.

Spare a thought for US bank regulators. On one side they have the banks, loaded with lobbyists, analysts and political contribution money fighting new regulations word by word. On the other, they have WikiLeaks, threatening to expose the private dealings of at least one leading US bank and show up the regulators’ lack of investigative muscle. Thrusting through the middle are the pitchfork-wielding voters and politicians eager to see bankers blamed and punished for the financial crisis.

Crisis always brings regulators and the companies they oversee into close contact, whether it is the US Food and Drug Administration and Merck over Vioxx in 2004, or the Securities and Exchange Commission and Goldman Sachs over the sale of mortgage-backed securities.

The financial crisis of the past two years, however, has led the banks and their regulators into new waters. The latter are trying not only to prevent another “too big to fail” scenario, but also to catch up with the warp speed and globalisation of financial innovation.

The banks, meanwhile, are trying to ensure they have a decent business once the political retribution has been wreaked. By many accounts, they have been effective in the US and established a model for other industries beset by crisis and the threat of increased government regulation.

“What’s evident from this crisis is the extent to which the banks have managed to get their way in spite of pressure from regulators,” says Rupert Younger, director of Oxford university’s Centre for Corporate Reputation. “The banks are very sophisticated and extremely well-connected. By sophisticated, I mean that they have armies of people who engage in the policy details of what regulations they’d like to see. By contrast, the regulators have only a small fraction of the manpower that the banks have, which creates a power imbalance.”

Cash and manpower, however, are not all it takes. The banks also showed an ability to separate political noise from permanent engagement with regulators.

Dealing with politicians can often descend into an ugly public spectacle. In January of last year, the heads of JPMorgan ChaseMorgan StanleyBank of America and Goldman Sachs respectively were grilled at a public inquiry into the financial crisis (pictured above). And in April, Lloyd Blankfein, chief executive of Goldman, appeared before a Senate panel investigating the bank’s role in selling toxic mortgage securities, only to be assailed by Democratic senator Carl Levin repeating expletives from Goldman’s internal e-mails.

But the effect of such theatrics seems to have been short-lived, partly because the political cycle is much shorter than the regulatory cycle. Provided companies can outlast politicians’ short attention spans, they can fight the real battles far from public view. And following November’s midterm elections, influence in Washington has tilted back towards the more banker-friendly Republicans and much of the heat seems to have gone from the attacks on banks.

“The regulators are very keen to work with the markets,” says Rob McIvor, a spokesman for AFME, the Association for Financial Markets in Europe, a trade group representing European wholesale financial markets. “There is no point in them bringing in regulations that don’t work.”

As the Basel Committee has been working on a new set of rules for Europe’s financial institutions, AFME and similar groups have put together teams of bank specialists to go over the committee’s recommendations line by line and offer suggestions. “We’ve found in general that regulators are receptive,” says Mr McIvor. He says the ideal relationship for a bank and its regulators should be “close and continuous” rather than confrontational.

Mr Younger says banks and regulators regularly second staff to each other’s institutions to understand the other’s activities better. “The banks have so much more power and artillery that it can become hard for regulators to get an unbiased and considered perspective. That’s been very evident in this last financial crash,” he says. “There have been regulation discussions since time immemorial, and there hasn’t ever been a time when financial regulation has been too tight.”

Critics argue, however, that too close a relationship can lead to a blurring of the lines between regulator and regulated. Investigations of the explosion on BP’s Deepwater Horizon rig last year, for example, found that the government agency meant to be regulating and inspecting it, the Minerals Management Service, had been lax in its work. The MMS had previously been criticised by Barack Obama, US president, for its cosy relationship with the oil companies it was supposed to regulate. The agency has since been renamed and is in the process of being overhauled.

Edward Kane, a finance professor at Boston College and keen critic of the latest wave of US bank regulation, believes that none of it addresses the government safety nets underlying the country’s financial system. He points to the Dodd-Frank act as an example of how the banks were able to influence policy away from the public stage of the Senate hearings. The banks knew they’d have another bite at the apple as the regulators came up with their rules,” he says.

Prof Kane believes that global banks regard regulation as a service that can be bargained for in multiple jurisdictions and through multiple layers of authority. If they do not like the regulation in one place, they move to another.

Also, while the biggest banks operate globally, regulators can only act locally. Mr Younger says this is part icularly frustrating for politicians in Europe. There is only so much a British policymaker can do when so much bank regulation is written at the pan-European level. “Banks are doing a terrific job managing the regulators,” says Prof Kane, especially in the US.

Jamie Dimon of JPMorgan Chase has been especially effective at managing through the crisis and arguing his bank’s position in Washington and Europe. He has made the political centres almost a second home, and become a trusted sounding board for regulators and cabinet members. He has, in short, made himself part of the solution, says Prof Kane.

Robert Merton, an economist at Harvard Business School, argues that there is a more fundamental challenge: financial regulations will al ways be outpaced by financial innovation. He compares the process to a hurricane: “Government policy can either reduce their devastation by establishing early warning systems or it can aggravate the damage by en couraging the building of housing in locations that are especially vulnerable to such storms. Government action can significantly influence the path of development of financial innovation.” But it cannot dictate the path entirely.

According to Mr Younger, the separation of politics and regulation is key. “There are two issues,” he says. “The public pressure on bankers, are they good or bad, then the much more important issue of regulatory reform. On the gritty areas of reform, such as capital adequacy, these matters are not interesting to the mass, but that’s the level of detail that regulators are interested in and which are of fundamental importance to the improvement of the financial services sector. The more populist stuff politicians tend to get focused on is very tangential to the real core issues for regulators.”

This has been apparent in the fights over bankers’ pay. Every swing by governments has been met by a feint from the banks. Cap cash bonuses in one year, and the managers bring the payments forward or delay them, or issue options instead of cash.

For the banks, separating the reputational and headline political disputes from the more humdrum but essential discussions over regulations has been essential to their success.

Two years after facing collapse, most are again thriving. In spite of their fears, the banks have managed to deal ably with the regulators. They are far from being regulated out of business. Whether this is good for the countries and economies where they operate will become clear when the next hurricane hits.

Tips for dealing with policymakers

●Maintain a close and continuous relationship.Regulation evolves constantly and should be treated as a strategic concern. It is not to be addressed only when regulators are breathing down your neck.

By maintaining continuous contact with regulators even in non-crisis situations, US banks remained in a good position to communicate in spite of the crisis.

●Separate noise from substance. After the onset of the financial crisis, public opinion turned hostile to the banks. Many politicians launched attacks on the sector. The regulatory response to the crisis, however, was planned far from public view, where the banks could make their case without their every move being scrutinised and painted in the worst possible light.

●Be the regulators’ best source of information.Companies know far more about what they do than the regulators that oversee them. By helping regulators understand your industry, you put yourself in a good position to help frame rules and legislation.

●Embrace the constraints.Regulations may impede some opportunities but open up others. Goldman Sachs might have had to cut back on proprietary trading. But its investment in Facebook reveals a fresh focus on serving investment clients and future investment banking business.



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