Can banking regulation go global?

Analysis
By Steve Schifferes
Economics reporter, BBC News

FSA: banks must 'absorb' shocks

In a dramatic switch of emphasis, the UK's Financial Services Authority (FSA), has decided to get tough on banking regulation.

Lord Turner, the new head of the FSA, has acknowledged that "'soft-touch' regulation has been consigned to the dust-bin of history" in the light of the "worst global financial crisis since the development of modern capitalism".

But to achieve its aim of preventing future banking crises that could cause even more damage to the world economy, the UK cannot regulate alone.

The FSA itself acknowledges that only a global deal on financial regulation will work, and that proceeding on a purely national basis "would be by far the second best".

Without a global deal, banks would switch their operations to places with lighter regulation, weakening the City of London, and the UK "could be exposed to financial stability problems" from other jurisdictions, the FSA says.

Lord Turner says the challenge "is that we have a global financial system, but no global government, and that dichotomy is not going to disappear".

Global deal

In many ways, the FSA proposals are a first draft of the plans that will go to the G20 London Summit in April, which has as one of its key aims the future regulation of the financial system.

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But that also means that its plans - especially for tougher capital rules for banks - now must go through a series of negotiations that could significantly weaken and delay their implementation.

Although there may be agreement on key principles, there is likely to be fierce debate on the details of how they might be implemented.

In particular, the issue of who should pay to rescue a major international bank if it was going to fail is still unresolved, as is the issue of how much international coordination there should be during future crises, including central bank intervention.

As Bank of England governor Mervyn King, pointed out, at the moment "global banks are global in life, but national in death".

Who is covered?

And there could be further difficulty on the scope of regulation, raising a question about how wide to cast the net.

One key principle that the UK is now putting forward is that "regulation should focus on economic substance, not legal form".

"If an activity looks like a bank and sounds like a bank, we regulate it like a bank," says Lord Turner.

But the US, with its more fragmented and rules-based system of regulation, might have difficulty in implementing such a principle, despite the aspirations of Ben Bernanke, the head of the US Federal Reserve, who has argued for a single US banking super-regulator.

The UK has also endorsed the need to assess the impact of the hedge funds and other activities that could in the future pose a risk to the system, a position strongly endorsed by Germany.

But regulating hedge funds, many of which are registered in off-shore financial centres such as the Cayman Islands, "would require such offshore centres to be brought within the ambit of internationally agreed regulation", Lord Turners says - something that could also be difficult to achieve without strong pressure from the G20 countries.

The US is also likely to be a somewhat reluctant participant in any global deal on how to limit bonuses to stop bankers taking too many risks, although a fierce political row has broken out over the large bonus payments to AIG employees after it received massive government support.

European complications

On the other side of the equation, any attempt to separate commercial banking from investment banking in the way the US did after 1933 would run into opposition from Germany, which has always had universal banks.

The FSA, for its part, has said that it is sceptical that "casino banking" can be easily separated from "utility banking".

However, it has come out strongly in favour of more European-wide banking regulation, arguing that the current system of passporting rights "is unsafe and untenable."

The FSA says that an EU-level Financial Regulatory Body is needed, with responsibility for overseeing national supervisors, helping the EU draft banking directives, and taking responsibility for early warnings about any major crisis.

This, the FSA admits, would be a "major change from the past philosophy", of which the UK has been the leading advocate, that the EU single market needed less, not more regulation.

And it is in itself another signal of the magnitude of the change that is sweeping international regulation.

Tensions

But none of this can be done quickly.

The last revision to the banking rules by the Basle Committee took almost a decade to agree and implement, yet the FSA seems remarkably optimistic that it can reach agreement on new tougher capital rules by the autumn.

Indeed, as the FSA itself says, there are reasons to go slowly, lest reform makes the banking crisis worse.

As the G20 finance ministers themselves pointed out, the biggest problem facing the world economy is still the overhang of bad debts and toxic assets held by the banks.

Neither the US nor the UK has yet implemented a comprehensive plan to rid the system of toxic assets. Adding more requirements to the banking system could make them lend even less.

So despite the FSA's bold words, banking regulatory reform may stay on the back burner for some time to come.