LONDON, 31 March 2008 — The City of London Corporation is supposedly the largest and most-influential financial center in the world. Over the last few weeks, its ceremonial head the Lord Mayor Alderman David Lewis, was trumpeting its virtues and strengths on a road show in the Gulf Cooperation Council (GCC) states, especially Saudi Arabia and Kuwait, with the hope of attracting the placement of inward liquidity with City-based financial institutions and the structuring of products and services to suit the needs of Gulf investors, including Islamic financial products, seemingly the flavor of the times.
But the vices and weaknesses of the City of London that have made the headlines over the last year is threatening to undermine its reputation — amassed over more than two centuries.
These include the impact of the US subprime mortgage crisis and its resultant credit crunch; the writing off by City-based financial institutions, like others in the US and the West, of millions of dollars of potential debt as a result of the subprime debacle; the run on Northern Rock, the UK mortgage lender so badly affected by the credit squeeze; the inept handling of the Northern Rock affair by both senior management, board of directors, the UK regulator the Financial Services Authority (FSA), and the government through the Treasury and the Chancellor of Exchequer Alistair Darling; the inevitable nationalization of Northern Rock by the government as part of its rescue plan; the market manipulation through unsubstantiated rumors behind the spectacular bear raid on the shares of HBOS (Halifax and Bank of Scotland), which nearly precipitated a run on the bank and necessitated a categorical denial from the FSA that the bank was not in trouble; and the losses of $1.4 billion incurred as a result of the illegal activities of a rogue trade at Credit Suisse in London ostensibly trying to ‘preserve’ his level of bonus in today’s uncertain financial climate.
It is important not to overstate the damage done to the reputation of the City as the premier global financial center. But the FSA’s report into its supervision of Northern Rock published last week is quite revealing and a remarkable indictment of the shortcomings of the City watchdog as the regulator of the world’s largest and most influential financial center.
The report admits a catalog of errors. The FSA admitted to poor record keeping; failure to keep proper notes of important meetings with Northern Rock executives; a failure to rigorously assess the Northern Rock business model and associated risks relating to its mortgage lending; and the almost farcical scenario of the lax supervision of Northern Rock as if it was literally the least risky bank in the UK.
This was not a failure of junior staff overlooking trouble spots through inexperience, but an institutional failure of the FSA monitoring and supervision regime for which senior management must bear responsibility. And yet thus far no heads have rolled.
On Thursday, Chancellor Alistair Darling announced that the FSA would be given new powers in its efforts to combat financial market abuse. The UK seems to be going down the US route of encouraging whistle-blowing and plea bargaining as a new weapon for the City regulator. As such, staff who are prepared to inform on colleagues who allegedly abuse the market through manipulating shares for gain through spreading malicious rumors; or indulge in insider-dealing or unauthorized trading, will be offered immunity from prosecution.
The opposition Liberal Democrat Shadow Chancellor, Vince Cable, while welcoming the move, warned, “It is about time that the FSA was able to take effective action to prosecute and curb criminal market abuse of the kind which destabilized HBOS last week. It has become apparent that, although it was possible to identify the people who benefited from HBOS short selling, the authorities were unable to gather sufficient evidence to bring a criminal prosecution. Failing to provide the FSA with the same whistle-blowing powers as other agencies was clearly an oversight, which has been belatedly put right.”
In the UK, HMRC (the inland revenue) and the Serious Fraud Office already enjoy these powers. In the past, cases involving financial market shenanigans and market abuse, have tended to peter out into minor offences because of the supposedly complexities of the case. The reality is that the market abusers and fraudsters often used sophisticated structures and corporate webs to hide their wrongdoings which often prompted their City lawyers pleading that a jury trial was not suitable in such cases because both the judge and the laymen would not understand the complexities of these financial structures and the cases would drag out, in some cases to years. They wanted instead a special tribunal to hear such cases because it would save time and therefore taxpayers’ money. Such arguments are spurious because they seek to treat potential wrongdoers as different to the rest of the population and therefore as special cases.
A few days ago, Conservatives leader David Cameron, in a speech to the City, stressed, “Britain’s economy is powered by financial services and in many ways that’s a good thing. The City of London is one of the most important industries in our country, and over the 20 years since the “Big Bang” it has generated wealth for us all, and allocated finance more efficiently throughout our economy and indeed throughout the world. But that doesn’t mean we need a credit free-for-all.
“The case for banking regulation is based on a simple fact. When banks succeed, they make huge profits. When they fail, other people - their creditors and in particular, in the case of Northern Rock, taxpayers - also pick up the pieces. This asymmetry between private reward and public risk is an argument for banking regulation - and closer regulation would be justified in other areas of the economy. We need to reform prudential banking regulation so that banks themselves, and regulators if necessary, act sooner. And we need to give back to the authorities the power to rescue a bank that is in trouble.”
Cameron also identified several areas that need to be dealt with on an international level. On capital adequacy, he stressed that the Basel II rules on bank liquidity are too weak. It is also not clear which asset classes and which institutions are covered by existing rules. “For example,” he stressed, “the zero-weighting of some triple A assets has led to distortions in asset allocation. Put simply, some of the debts were kept off the balance sheet so they didn’t count as lending under the rules.”
He criticized the practice where judgments about credit risk were delegated to rating agencies who themselves had incentives to expand the amount of lending that was allowed under the rules “because they are paid fees for rating debts.” Finally, market risk was measured by backward-looking models, which tend to exacerbate the credit cycle, not dampen it. When credit is easy, the models allow more lending. When credit tightens, the models reduce the amount of permitted lending.
Others would go even further and suggest the financial sector in the City as elsewhere is consumed by what has been called “the greed game” and that the banking sector, being privately-owned, is treated as too private. This has given rise to a risk-reward scenario which is heavily in favor of the hedge fund managers, private equity managers and others who stand to earn millions of dollars in both salaries and bonuses when the deal goes right, but who do not share in the risks if the deal goes wrong, often leaving taxpayers to bear the burned as in the case of Northern Rock.
