We have not witnessed anything like it in living memory—not Suez or the Russian invasion of Hungary, the Vietnam war or the 1970s oil crises or property slump, the Russian invasion of Afghanistan, the Falklands War, the stock market crash of 1987, the property slump of the early 1990s or the dot-com bust of the early 2000s.
A fundamental fear has gripped the world's financial markets and brought the financial system to the verge of catastrophe.
The roll call of the great financial institutions brought low is extraordinary. The nationalisation of Northern Rock now seems like little more than a distant warning of things to come. Bear Sterns, Lehman Brothers, Washington Mutual, HBOS, Royal Bank of Scotland, Bradford and Bingley, Landsbanki and Kaupthing are all now members of the financial Hall of Shame. But they are far from alone.
At the time of writing Libor rates are creeping steadily downwards and world stock markets seem to be edging upwards. But what happened to the regulatory system which was meant to prevent things like this? And what do we do now to ensure it doesn't happen again?
What is clear is that Sarbanes Oxley and the flood of U.S. financial regulation introduced following the fall of Enron and Worldcom has not worked. That legislation has done nothing to support confidence in financial statements—particularly those of significant financial institutions whose asset valuations seem to have been hopelessly flawed.
Indeed the crisis has come at a time when the global accounting industry is still trying to get to grips with the new paradigm of value accounting. How can you "mark to market" when the markets can no longer be trusted? How can you "value" an asset whose value no one knows?
Yet there are many who blame the meltdown on a lack of regulation. It could easily be argued that the markets crashed in 1929 because there was no regulation. In response the U.S. Securities Acts were drafted and the Securities and Exchange Commission brought into existence.
No one can argue in 2008 that we have no regulation. Indeed we have never had more regulation.
So which regulations have worked?
It would appear that in the UK the government has found a whole new use for the Anti-terrorism, Crime and Security Act 2001 introduced in the immediate post 9/11 era to target the funds of criminal organisations. On 8 October HM Treasury issued an Order under that act to freeze funds owned, held or controlled by Landsbanki, or by the Icelandic authorities or the government of Iceland in relation to that bank. The Order affects any person in the UK or any person elsewhere who is British or a body incorporated or constituted under the law of any part of the UK. The government's published rationale was its "concerns about the detrimental effect on the UK economy of the current situation" and to help ensure that UK wholesale creditors of Landsbanki are treated fairly. For these purposes "wholesale creditors" appears to mean anyone who is not covered by the FSA-administered Financial Services Compensation Scheme including local authorities and quangos. It can come as little surprise to anyone that the Icelandic government was none too pleased.
The Enterprise Act 2002 provided for the secretary of state for business and enterprise to intervene in mergers in order to protect legitimate public interest considerations. Hitherto these were limited to national security and plurality of media ownership. However new considerations can be added with the consent of both Houses of Parliament. On the 18 September, following the announcement of Lloyds TSB's proposed merger with HBOS, the secretary of state announced he would seek to add a new public interest consideration—"the stability of the UK financial system." If Parliament passes the relevant order the secretary of state will have the power to override other competition issues in making his final decision on the proposed merger.
The Banking (Special Provisions) Act 2008 was enacted following the nationalisation of Northern Rock last year. It came into its own at the end of September allowing the government to acquire all the shares in Bradford & Bingley and transfer its savings business and branches to former rival Abbey National, part of Spanish bank Santander by issuing a Transfer Order. Barely 10 days later the same process was used again to allow the government to transfer the savings and deposit accounts of Landsbanki, including its Icesave deposit accounts, and those of Kaupthing to Dutch bank ING.
But the majority of the UK's regulatory system would appear not to have worked.
The £35,000 guarantee for retail bank deposits under the UK's Financial Services Compensation Scheme appears to have been woefully inadequate and, on 7 October, was upped to £50,000. However the Irish government had beat the UK to it by a matter of days guaranteeing the full amount of all deposits, retail or otherwise at all Irish banks.
In spite of its well advertised limits, the UK government has not felt able to rely on anything less than 100 percent backing for all retail deposits and has done what it can to outsource the liability—as illustrated by its drastic action in relation to the Icelandic banks, passing the liability for retail deposits on to the Dutch National Bank's Deposit Guarantee Scheme which guarantees up to €100,000 (approx £77,700) per depositor and freezing the UK assets to help meet the claims of those not covered.
The remainder of the FSA handbook has proved little comfort to those investors trying to deal with the U.S. bankruptcy and UK administration of Lehman Brothers. Assets worth billions of dollars are frozen following the cessation of trade of the once mighty financial leviathan. Those who were dealing through it when the music stopped are left with the unenviable task of unpicking the strands one by one. The lack of transparency around stock lending "Lehman style" will leave the administrators and frustrated creditors with years of work to come. The unanswered question is how will those corporations with significant stock positions the subject of "hypothecation" and "re-hypothecation" to the extent that no one can really say who owns it, be impacted in their ordinary business—communicating with investors, raising cash, obtaining shareholders consent, carrying out tender offers and so on?
And it is painfully obvious that regulations are no good at forcing banks to lend to each other. Gordon Brown's UK bail out scheme has relied on government guarantees of inter-bank lending to restore confidence in the system. So the UK taxpayer has had to put its hand in its pocket to coax hard nosed bankers into lending some of their cash piles to each other.
When first announced on 8 October, the government's plan was to increase the capital of the eight major UK banks by £25 billion through a Bank Recapitalisation Fund. A further £25 billion was to be available to other eligible banks and building societies. In the following days, however, each of the major banks seemed to distance itself from the idea of taking taxpayers cash.
However by 13 October things had changed and HBOS, Lloyds TSB and RBS had agreed to take significant amounts of additional capital. HBOS agreed to take up to £11.5 billion with a further £5.5 billion going into Lloyds TSB on completion of their merger leaving the government with around 44 percent of the merged bank and two board seats. RBS agreed to accept up to £20 billion of additional cash representing a potential 63 percent government stake with the right to appoint three board members.
What changed? On Friday 10 October the banks were told to raise their original estimates of how much extra capital they needed. That same weekend the finance ministers of the G7—the USA, Canada, France, Germany, Great Britain, Italy, and Japan—met in Washington with the managing director of the International Monetary Fund, the president of the World Bank and the chairman of the Financial Stability Forum. The focus was on taking decisive action and using all available tools to prevent the failure of systemically important financial institutions. The pressure was on the big UK banks to increase their Tier One capital ratios to make them "bomb proof." Final ratios close to 9 percent were agreed late on Sunday 12 October. While HSBC were already close to that ratio RBS, Lloyds TSB and HBOS were each some way off.
But it appears to have been political pressure rather than regulation which caused the big banks to sign up to the rescue plan.
So what is the prognosis for future regulation?
There is no doubt that the UK government is now firmly in the driving seat at the big UK banks. The other countries following the UK's lead in their own domestic bail outs will likely end up in the same place. That could mean that significant changes in banking practices could be achieved without the need for any additional regulation at all. The boards of the banks could simply set policies on credit and lending which would address the inadequacies of the past.
But politically that is unlikely to be enough. We live in the age of government by sound bite. It will be vital, come election time, to be able to say "something has been done." The easiest thing to do is to point at a shiny new rule book. The temptation to create new rules is huge. It would take politicians of real stature to stand by the message of our regulatory history that rules alone do not work. We have lots of rules—and some of them are very fine rules.
It is integrity in their application which is the problem. On 14 October, Hector Sants, chief executive of the FSA, admitted that it was "clear that a number of banks, notably those that became dependent on wholesale funding, went into the crisis with business models ill-equipped to survive a stress of this severity, and we [the FSA] could have done more to minimise this, a fact that we regret." His solution to the problem is not more rules but "a culture that attracts and retains quality individuals, and which encourages decisive yet considered judgments....We have also been clear that we need the right people in the right jobs: the right mix of career regulators and experienced market practitioners."
To prevent a crisis of this magnitude occurring again is going to require courage, integrity and imagination. Not a wholesale re-write of the rulebook.
This article was first published in the December 2008 edition of International Financial Law Review Magazine.
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