Lessons of an ex-regulator

Sir Callum McCarthy, until recently the chairman of the Financial Services Authority spoke at the School on Tuesday night at the MSc Finance 10th Anniversary celebration.

By Elliott White

Sir Callum McCarthy, who two weeks ago stepped down as the chairman of the Financial Services Authority (FSA), was in reflective mood this Tuesday.  He spoke to financial leaders and alumni of Imperial College Business School at an event celebrating ten years of the School's MSc Finance programme.

Whilst not making specific comments about the financial regulator’s role in the current financial turmoil, he gave three areas for important legislative change. 

These were regulation of capital requirements, liquidity management and more effective international regulatory collaboration.

“Far reaching changes to the rules of finance,” Sir Callum said are called for. These will help develop a regulatory “framework less susceptible to the severely damaging consequences” of the market.

Questions over Basel II

On capital requirements Sir Callum questioned the underlying approach to risk management previously taken.  “It’s clear that the reliance which was placed on the ability of financial institutions to manage and control the risk they undertook was not justified,” he said.  Repeating comments made at his last speech at the FSA that this is a systematic issue, he said: “This is not a problem of fringe players or financial cowboys.”

On the topic of leverage – the use of credit or borrowed funds to improve speculative capacity and increase the rate of return from an investment – he said that: “The amount of leverage deemed to be acceptable will, in future be significantly less and lower than has been in the past."

These comments rub against the work of the Basel Committee, an international group defining banking rules which has been working to address these very issues.  Sir Callum said that the use of off-balance sheet vehicles, the measurement of leverage and the accounting for banking trading books will all require reopening by the committee.

Professor David Miles, founder MSc Finance programme, with Professor David Begg and Sir Callum McCarthy

On the matter of liquidity, or cash available to banks at any given time, Sir Callum felt progress would be more difficult as it is a more illusive and less easily quantifiable issue.  It is linked to the policy of various central banks, each determining what is acceptable collateral against their own lending and when payments should be made.

“There is an absence of international agreement on [liquidity policy],” he said and painfully slow progress had been made so far.  Adding progress is so urgently needed that it may need to come about on a national basis first, rather than waiting for international agreement on the issue.
The final point, the need for international collaboration was made by drawing out the fact that the duties and legitimacy of regulators derive from legislation made by politicians.  The closest the speaker came to overtly defending his former organisation. Naturally the delegation of power leads to a tension between those elected to rule and those appointed to regulate.

“When the lights go out, or there’s a systemic failure in finance, politicians know they will take the blame. Yet it is the responsibility of the regulators to serve out the duties they have been given,” he said.

In the inevitable and important process of reassessing the current crisis, “Ministers and their officials must get to grips with the reality that they have created.  Namely the ceding of decision making powers on important decisions to an independent body,” he said.

Adding the international dimension to this charged situation is a problem that needs to be addressed.   For example, a policy of deposit guarantees is set up in one country but not another will create difficult tensions unless, “there can be some international underwriting of the costs of failure,” he said.

Ends

If you weren't able to come to this celebration, a film of the event will be available here shortly.

The next event will be a special invitation only lunchtime event on 26 November when Professor Bob Shiller will introduce his new book, Subprime Solution.