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Swiss Finance Academy

Three models of financial regulation

Sharks circle Paulson's Aussie plan;

To simplify heroically, there are three main models of financial regulation in operation around the globe. The first is functional regulation, whereby separate regulators oversee different types of financial company. Most countries have moved away from that model, on the solid grounds that financial markets themselves have become more interlinked and companies more promiscuous. The US is a prominent exception. Americans have remained as committed to a highly complex form of functional regulation as they are to suit trousers that ride above the ankle.

The second model is unitary regulation, with a single institution covering most if not all of the financial sector. Although this model is often associated with London and the Financial Services Authority, the Scandinavians started the trend on the back of the banking crises there in the early 1990s. Following the UK switch a number of other countries, including Japan, South Korea and Germany, did the same. Now more than 50 countries operate something similar, although no two models are precisely the same. Time was - way back in August 2007 - when the unitary authority strategy was carrying all before it. In the ANR era (After Northern Rock) some of the gilt has gone off that brand, although the underlying logic remains strong.

The third scheme is known in the trade as Twin Peaks - a long-forgotten US television series not adorned by Kylie - whereby two regulators are established: one for prudence, focusing on capital soundness, and one to monitor the general conduct of business standards. So far only two countries have followed this prescription, originally devised by UK academics: Australia and the Netherlands. They have done so in subtly but importantly different ways. In Amsterdam the central bank is the prudential regulator. In Sydney there is a separate authority, leaving the Reserve Bank withscrutiny of the payments system and responsibility for financial stability.

After a brief global tour the US Treasury has come to rest near Sydney Harbour, a very agreeable location, one must admit. The Paulson plan would strip the Fed of its direct role in supervising bank holding companies and give it instead a broad remit to look for trouble across the financial system. In an important sentence in his speech Mr Paulson gave a hint of his reasoning, and a clear warning to the investment banks. "It would be premature to assume," he said, "these institutions should have permanent access to the discount window and permanent supervision by the Fed." The Treasury is clearly nervous about the growing assumption in the markets that brokers will continue to be able to deposit mortgage securities, food stamps and dead mice at the discount window in return for hard cash. I suspect this will be a hard proposition to sell to Congress, however logical it may be.

Lunatics running the asylum?

Could it turn out like those times?

Depression, You Say? Check Those Safety Nets;

“I used to give a lecture explaining that the Great Depression could never happen now because of the regulations that emerged from that crisis,” said Barry Eichengreen, an economist at the University of California at Berkeley. “But we’re learning that there is a shadow banking system, of hedge funds and investment banks, that are outside of those safety nets. What happened to Bear Stearns last week looked a lot like a 19th-century run on the bank. And that’s why the Fed reacted so quickly.”...

“To understand the Great Depression is the Holy Grail of macroeconomics,” Mr. Bernanke wrote in a 1994 paper, when he was a professor at Princeton focused on analyzing the financial cataclysm that began in 1929. While economists have made great progress, he continued, “we do not yet have our hands on the Grail by any means.”

Quote of the Day

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."

-Thomas Jefferson

Related;
Hamilton vs. Jefferson: Whose economic vision was better?

It is well known that Hamilton and Jefferson disagreed strongly about the national bank. Hamilton was the architect of the First Bank of the United States, believing it essential to the financing of the federal government and to the establishment of a robust domestic banking system. As such, Hamilton is considered a pioneer of central banking and a forebearer of the modern Federal Reserve. Jefferson believed the bank would put too much power over the government in the hands of the bank’s owners.

But the issue went deeper than that. Jefferson, in fact, didn’t like banks at all. Steadfast in his belief that working the land was the only “honest” way to make a living, he saw bankers as essentially swindlers, and he didn’t trust them. Hamilton, by contrast, thought banks were to be a vital part of the American future—if we want a strong economy, we need lending, and lending is the business of banks. Better to have American banks doing the lending, he argued, than British or other foreign banks.

This disagreement is part of a long history of controversy about banking. There are basically two opposing views: One sees debt as essentially bad and looks at bankers as exploiting borrowers’ bad fortunes or poor judgments; the other sees lenders as providing a useful service for which there is enough demand that borrowers are willing to pay interest.

In retrospect, it may seem obvious that Hamilton was right, at least in predicting how America would develop. But this controversy is still alive, and Jefferson’s voice can be heard today, for example, in the reaction to problems in the subprime mortgage market.