I recently interviewed Paul Sharma, Director of Policy at the Financial Services Authorities for Germany’s Handelsblatt. Among other things, we talked about the Libor scandal, the cultural change in the financial industry and the new toughness of British banking supervisors. Here’s the English version of the interview that is published in today’s edition of Handelsblatt.
Mr. Sharma, some people familiar with London’s financial industry assert that you’d only need to dig deep enough at any part of the financial system and would end up finding things similar to the Libor scandal.
There is probably some truth as well as some exaggeration in that statement. It is undoubtedly the case that during periods of prosperity, such as we had before the credit crunch, inappropriate conduct can occur and apparently not have consequences, because it is obscured by the rising tide of prosperity. A lot of that conduct only becomes apparent during periods of economic downturn.
Hence the Libor scandal is just the tip of the iceberg?
I don’t doubt at all that the particular, very public instances of very inappropriate conduct are not just serious in themselves but also evidence of a wider problem. But equally I don’t think that banking in itself is 100% inappropriate conduct. There is a very significant part of the activity that is good and helpful to the economy.
What can regulators do to fight fraud in the financial industry?
Quite a lot. We can look at the whole question of culture in banks and insurance companies, at the quality of the management and the governance as well as the internal and the external audit. We can also look at the incentives. All of that is relevant to the prevention and the detection of inappropriate behaviour. It is of course the case that regulation can’t have a 100% prevention rate in such circumstances.
A lot of people complain that five years after the crisis has begun the bankers are carrying on regardless.
I don’t share this view entirely. I think that there has been the start of a cultural change in the banking sector. I don’t think that it is by any means complete. However, amongst the mayor UK banks, there is now a recognition of serious financial consequences flowing from inappropriate behaviour. The senior management is aware of the serious reputational damage and possible financial consequences for the individuals concerned. That is having an effect on the way in which senior management of banks approach risk.
Can you give any examples? Is there any institution that you’d consider as a role model?
I hesitate to name any particular institution. The most profound cultural change has and is occurring in the institutions that got into the greatest difficulty. The closer they got to a near death experience, in general, the more transformed their culture was.
Are there any means a regulator can affect the culture?
Yes, but it’s difficult and it’s not necessarily instantaneous change. One of the most important ways is attaching consequences to past wrong doing, and doing that in a public way. That has effects beyond just the institutions in which it occurs. Secondly, we have a strong emphasis on supervisory practice, on looking at the business models of banks and insurance companies. How do they make their money? How are they profitable, how is that aligned to the needs of their customers, what risks do that pose to public interest?
What would happen if you came to the conclusion that a certain institution doesn’t have a viable business model?
We would challenge the senior management of the institution and a number of regulatory actions are possible. We can seek to increase the capital or increase the sum of liquid assets. We can also restrict the way in which they are selling a particular product or give public warnings to consumers.
The British banking regulators used to be proud on their “light touch” approach. Banks and insurances were only very lightly regulated.
These days are gone. In the middle of 2007, we had a fairly fundamental paradigm shift. If you compare 2012 to the early part of 2007, we could have been living in a different age. It’s like before and after the industrial revolution.
How would you describe the new paradigm?
The new approach is the regulator needs to be very focused on a relatively small number of very important issues . We must not be afraid of asserting very vigorously that the public interest may differ very significantly from the private interest of people in the market.
This implies much stronger interference into the things going on in the financial system?
Correct, and I don’t shy away from the word interference.
Can you give a concrete example?
Take the regulation of banks liquidity. We’re quite clear that the new liquidity regime for banks needs to be one where the tail liquidity risk – the risk in liquidity stresses – is predominantly borne by the banks themselves. However, the banks have an interest in shifting the risk to the state because that means more profits. So we have an interest in banks holding significant amounts of liquid assets that can be used during periods of stress rather than the banks going straight away to the state.
What are the most pressing issues in field of banking regulations?
Our two biggest problems are “too big to fail” and shadow banking . “Too big to Fail” has a number of causes and therefore needs more than one solution. One of those causes is the interconnectedness of activities whose continuation is essential to the economy and those that aren’t. Currently, you either safe both or you let both fail.
The UK is trying to get to grips with this by ringfencing risky parts of banking from the rest. However, if you take Northern Rock or Lehman, ringfencing would not have helped to prevent the problem, would it?
Well, you have to address two separate questions here. The first is: Does ringfencing solve all of our problems? The answer is clearly no. You just gave two good examples, Northern Rock and Lehman. In both cases, ringfencing would have contributed very little, virtually nothing. The second question is: Does it solve some of our problems, some significant problems? Yes! Very definitely. The part of the bank that is not protected has to pay higher funding costs and higher capital costs on the basis of its stand-alone position without implicit government support.
Compared to the optimal state of banking regulation – how far has the UK got?
There’s very significant progress but there is still a fair amount to do. And let’s be clear: There is no permanent steady state that is the right answer to banking supervision. As soon as you do change supervision and regulation, the market itself changes. Shadow banking is a very good example. As soon as you change regulation, where and how shadow banking occurs changes. Therefore one needs to be constantly adaptive and have an adaptive capability in both the supervision and the design of the regulatory system. We should never believe that we have actually achieved the perfect answer.
Banks are operating globally, while regulators act along national borders. How big of an issue is this?
We’re still on the journey of making the cooperation work between the supervising authorities around the world and also particularly within the European Economic Area. That’s clearly an area where more progress can and should be made.
How does this square with the fact that the UK government is fighting for exclusions for the City of London in Brussels?
In my area, banking and insurance regulation, the UK government is seeking exclusions from maximum harmonisation in order to demand more of UK banks and insurance companies than the EU standard. One can call it an exclusion for the City, but it’s an exclusion to be tougher on the City.
Why do you want to be tougher?
This is partly motivated by the size of the financial sector relative to the size of the economy. The larger the financial sector is compared to the economy, the tougher is the desire for regulatory standards to be. Pre-credit crunch you could see an opposite relationship.
You previously mentioned incentives. Do think that the remuneration of bankers should be regulated more tightly?
We strongly believe that the principles of the G20 stated in respect of remuneration…
… the idea that bonuses should be deferred and linked to long-term goals …
… need to be fully applied throughout the world. Europe has taken a lead in this but we need the rest of the world – particularly the other G20 nations – to apply these principles vigorously and strongly.
Does it really help to pay a bonus two or three years later? Prior to the crisis, thanks to many years of growth and success, that would not have made a big difference.
Yes, that’s right. But, again, one should not fall into the trap of saying: Each solution must solve every problem. If that’s the test, we’ll end up doing nothing. There is no one solution that solves every problem. Can having a strong and coherent regime on remuneration and incentives play a significant part in the solution? Yes! Absolutely, definitely, yes!
There is a big academic literature about regulatory capture – the issue that any regulator in any industry becomes to closely entrenched with the industry it supervises…
… the Stockholm syndrome ….
Precisely. How do you address this problem?
Again, there is no simple solution. One part of the answer is that we’ve changed our decision-making process. The Stockholm syndrome happens because you’re dealing with a particular firm for a long period of time. That’s less of a problem for senior people. Nowadays, at the FSA, key decisions are being taking by a smaller number of people who are at the senior level. Those people are less attached to a particular firm and more experienced. There’s also a good degree of collectivisation of key decisions amongst the senior team. Another part of the answer is there is clearly now much greater scrutiny by the outside world, by parliament, by the other European supervisors, by the European institutions, the press and the public. The continuation of that scrutiny is also part of the answer.
How difficult is it for a regulator to attain the best people as employees? In general, the private sector pays much better.
There is some truth in it but it is by no means wholly true. You can’t have a salary structure in a regulator that is wholly detached from the outside world. But neither do we need to pay the same as the banks in order to attract staff because there are some very significant non-salary advantages in working for a regulator.
For instance, the breadth and quality of the work, which is important to a number of people. The moral level is another advantage: people feel good working for us. Additionally, even if you were trying to maximise your salary over your career rather than over the next year, it still makes sense to work for the regulator for a number of years. There are some powerful pluses going in our way that mean that the question of attracting staff is not as bad as a simple, straightforward comparison of raw salary numbers might suggest.
Probably the crisis has helped in that respect?
The crisis means that there are fewer opportunities out there. We are hoping that the crisis will come to an end, nonetheless.
The FSA will cease to exist next year. How will this affect banking regulation in the UK?
It’s a continuation of the journey, a further significant step. The FSA will split up in two regulators, the Prudential Regulation Authority and the Financial Conduct Authority. This will be a significant staging post in the journey to very more effective regulation in the UK. Structurally, it is a deep change, but significant parts of this deep change are already put in place in anticipation of the change.
The banking industry itself complains about overregulation and warns that London as a financial centre might be damaged.
I largely don’t think there is a good case in terms of too tight rules. It’s clear that pre-credit crunch, there was a lot of risk that was being taken where the benefit was going to industry participants but the downside risk was being borne by the state and by the public. We will not return to those days.
How will this affect the banks?
It means even when we return to prosperity, the costs of doing business will be higher. This will be because all of the costs will get counted. People who get the benefits also bear the risks. That feels tougher to the industry. But, sorry, that’s how capitalism should work.
So there’s no danger of overdoing it?
I don’t doubt that – with all the regulatory change that is being made globally, on the European level and at the national level – some bits will need to be revised and re-interpreted at the level of detail. There is further work to be done that may involve turning this piece of regulation down or increasing that part. But I don’t buy the basic argument, that there is too much regulation.