Bank of Spain Chief
The land-mark Glass-Steagall Act of 1933 became the bulwark of a renovated US financial regulatory system approved as a result of the financial collapse of the late twenties and thirties and propelled the separation of commercial and investment banking. As George Benson noted, at that time ‘a quarter of the formerly working population was unemployed… Over 11,000 banks had failed or had to merge, reducing the number by 40% from 25,000 to 14,000. The governors in several states had closed their states’ banks and in March FDR closed all the banks in the country’.[1] Despite these hard facts, bankers, economists and politicians hold serious reservations as to the empirical evidence that irrefutably proved ‘the belief that banks’ securities activities or investments caused them to fail or caused the financial system collapse’,[2] though this remains the widely accepted belief along with a perceived conflict of interests within banking and finance that purportedly fraudulently mislead investors. This inevitably split JP Morgan (the bank), which retained the right to issue checking accounts, and Morgan Stanley (the investment bank), which took over all corporate underwriting.[3] Nonetheless, ‘banks could underwrite municipal general obligation bonds and act as agents for private placements (unregistered securities that cannot be sold to the general public at large)’.[4] But adherence to Glass-Steagall began to erode by the 1960s ‘when banking organizations began using one-bank holding companies as a means of entering non-bank activities, such as mortgage banking, leasing, and data processing’,[5] effectively conducting these activities through non-bank subsidiaries. As a result, the amendments to the Bank Holding Company Act authorized the Federal Reserve to become the arbiter of appropriate or inappropriate activities which itself produced a cat and mouse race for the loopholing of banking and investment activities eventually facially resolved by the courts.
Further, the Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Depository Institutions Act of 1982 effectively dismantled Regulation Q,[6] which produced one positive and one negative result. On the upside, deregulation
allowed the Savings and Loans [S&L] businesses (as well as other depository institutions) to compete for funds as money market rates skyrocketed in the early 1980s. The bad news was that S&L had been induced by regulations to invest in primarily long-term (usually 30 year) fixed-rate residential mortgages. Thus S&Ls were stuck with mortgages made in the 1970s or earlier, most of which were earning less than 8 percent, while they were renewing their short-term deposits at rates that were nearly double that…. Estimates by academics at that time indicated that the industry had a negative net worth of as much as $150 billion by the end of 1981.[7]
In broader terms, the banking and finance world’s troubles were aggravated ‘as high-quality borrowers moved to the commercial paper market during the 1970s and 1980s, [and] banks extended loans to borrowers with riskier prospects. Thus, banks were especially vulnerable to the international debt crises that emerged in the 1980s and economic shocks that plagued the oil industry, farming, and real estate industries’.[8] After 1989 when the Federal Reserve granted five banks the right to underwrite corporate debt banking regulation got even more complicated. It would be the subsidiary of the holding company (called Section 20 Affiliate who would be responsible for the underwriting). To minimize commercial banks exposure, the Federal Reserve required Section 20 affiliates to be insulated from the banks activities with barriers called fire-walls, separating their operations. It was believed at the time that conflicts of interests would be prevented by regulatory fire-walls which would, among other things, restrict the bank from channeling funds to the securities affiliate through the bank holding company.
At the international level, whether banking oriented economies such as Hausbanking in Germany or Keiretsu relations in Japan ruled, in contrast to the more market oriented British wholesale banking and US banking, cultures became irrelevant. Indeed foreign banks edged US banks in competitive advantage even though the consolidation of US commercial banks solidified in the 1990s, thanks in large measure to the attractive Eurobond market. As a result ‘financial innovation’ initiatives were presented to restore this competitive advantage. These, however, bordered on circumventing financial regulation. As Ritter and others explain, the ‘[c]ircumventing of regulatory constraints has been an important element in stimulating recent financial innovation, but it has not been the sole motivating factor. Other forces such as double digit inflation that characterized the 1970s, progressive legislation, the philosophy of deregulation, and the burst in technological advances were important as well’.[9] In this regard US Federal Reserve Chairman, Alan Greenspan, affirmed in 1990 that ‘[i]n an environment of global competition, rapid financial innovation, and technological change, bankers understandably feel that the old portfolio and affiliate rules and the constraints on permissible activities of affiliates are no longer meaningful and likely to result in a shrinking banking system’.[10] This led American Banks to accommodate to the universal banking norms whereby banks hold ‘more direct control [over clients and contractual covenants, and collateral] via their influence over firms as stockholders or as the agents of stockholders’,[11] which produced the expansion of American banks and financial entities’ influence in international markets. As a result, American style universal banking became standard reference as emphasized by the growth in the bank loan sales market operating in Europe. As Calorimis notes, ‘[i]n explaining the rise of this market, bankers point to increasing pressures to conserve scarce bank capital and boost returns on equity’.[12] In addition, in 1999 US banks gained a competitive edge in universal banking as Glass-Steagall limitations on private securities underwriting were lifted. Clearly, deregulation of banking and financial markets in Europe would be slow coming as a result of the more favorable protectionist policies of European integration after 1999, but accommodation of American style universal banking would become the norm in the international stage.
Throughout the latter part of the XX Century, as globalization accelerated so did the interrelationship and interdependence of financial markets. Because appropriate integration of these never consolidated as expediently as would have been required, the probability of the occurrence of financial systemic risk grew exponentially. Simultaneously, the Bretton Woods financial institutions, (i.e., IMF, World Bank and WTO) tasked with an important dimension within the regulation of international markets laxed their supervisory practices in the interest of increasing market liberalization. The speed with which market liberalization was being applied led National Central Bank Governors and Finance Ministers in many countries to realize that some sort of international regulatory agreement was imperative for the new wave in the world of finance to be effectively controlled. To overcome this challenge, states formed international financial institutions (IFI) to manage systemic risk in global markets. Thus, several non-legally binding Agreements were reached in the post-Bretton Woods era geared towards this end. The main guarantors of the renovated international financial regulation system became thenceforth the Basel Committee on Banking Regulation and Supervisory Practices (BCBS); the International Organization of Securities Commissioners (IOSCO); the Financial Action Task Force (FATF); and the International Association of Insurance Supervisors (IAIS). In particular, the BCBS born in 1988 (Basel I), composed by the central bank governors and national bank regulators of the G10 countries arises as the main reference with regard to international banking and finance regulation.[13]
The main objective in Basel I was to make recommendations for the establishment of minimum capital requirements for commercial and investment banking in terms of capital risks associated with these institutions enterprises. However, Basel I is limited in its capacity as it fails to assimilate risk fluctuations and ignores credit quality. Simultaneously, non-legally binding implications, along with questions over Basel I legitimacy and accountability practices have seriously hampered the end for which it was created. Nascent regulatory frameworks are certainly always imperfect and need a period of time to become normalized before they are perfected. In this regard, Kern Alexander and others agree that, ‘[m]ost international standards and rules for banking regulation and supervision have evolved from a purely nonbinding and voluntary role to an increasingly precise and obligatory status backed by both official and market incentives and sanctions… [However] The haphazard development of these international standards and their uneven application to developed and developing countries has produced a vast but loosely coordinated, international regulatory regime that is ill equipped to deal with threats posed by today’s globalized financial markets’.[14]
Clearly the speed with which deregulation, technology and ‘financial innovation’ advanced impeded appropriate regulatory oversight. Singular bank and financial institution failures aside the experience of the debacle of Japanese banking in the 1980s along with the tech-bubble burst in the early 1990s, to the Asian market crisis in 1998 confirm this stance. In this environment the ex-Governor of the Bank of Spain (1992-2001), named best central banker in Europe for four straight years, Luis Angel Rojo, declared recently that he viewed for many years Alan Greenspan’s policies as absurd and was very critical of IMF chief Dominique Strauss-Kahn and the European Central Bank (UCB), but that nobody seemed to care to effect appropriate regulatory policies. Only France considered applying a similar conservative position but finally relented.[15] Now the Financial Times acknowledges Mr. Rojo’s performance when the Bank of Spain under his mandate in 2000 ‘furtively “gold plated”—or rewrote—European Union rules to discourage Spanish banks from creating entities such as structured investment vehicles (SIVs). And when banks such as Santander embarked on an acquisition spree in Mexico, the central bank reined them back’.[16] The Economist agrees with the Financial Times, but goes even further to explain the specific measures undertaken by the Bank of Spain:
The first was to demand that banks set aside the same amount of capital against assets in off-balance-sheet vehicles as they would against on-balance-sheet assets. That may not have squared with the rules of the outgoing Basel I accord, which offered capital relief on off-balance-sheet activities, but it did fit international accounting rules on consolidation…. The second policy does clash with international accounting standards. Since 2000 the Bank of Spain has had something called a “dynamic provisioning” regime, where bank provisions go up when lending is growing quickly. The scheme is based on the difference between banks’ specific provisions for identified losses in any given year and a “statistical” provisioning amount that reflects average losses on assets over the whole business cycle.[17]
But the Bank of Spain regulation is not perfect. As the Economist also points out ‘[t]he statistical provision, which the Spanish banks calculated using data from two business cycles, is based on the assumption that all cycles are roughly similar, which they plainly are not’.[18] Despite this instance clearly these two supervisory instruments prevented toxic banking and financial practices from entering the Spanish economy even as the real estate market began to cool down.
By 2004 corporate accounting scandals in the US and abroad encouraged strict enforcement of the 2002 Sarbanes-Oxley Act, better known as the Public Company Accounting Reform and Investor Protection Act, and the harmonization of its foreign equivalents. This new regulatory drive led international regulators to approve a second round of regulatory and supervisory practices rules in a second round of Basel agreements (Basel II) in 2004 at the BCBS. In particular Basel II encourages home and host country regulators to work together to coordinate and cooperate when supervising complex financial conglomerates or what has commonly become known as application of the principle of consolidated supervision. Basel II is divided into three key pillars emphasizing (1) Capital adequacy assessments; (2) Assessment of internal controls and risk management practices for each affiliate and subsidiary within the banking group; and (3) Increases in the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.[19]
The complexities of harmonizing, applying and enforcing Basel II across banking and financial systems differently, not only culturally but also structurally, question its viability. At the same time there is concern over the implication that the principle of consolidated supervision may be applied decidedly in favor of the home country enterprises thereby ‘increasing systemic risk in many jurisdictions, especially for developing and emerging market-economies. Moreover, although it [Basel II] seeks to respect national legal principles regarding confidentiality of information held by the supervisor, the enhanced framework for cooperation and investigations may undermine the local authority of non-G10 regulators to utilize alternative capital adequacy standards in their countries.[20] Thus, what may be presented at times in mainly Western media outlets as an uncooperative response by developing and emerging market-economies to universal banking thrift should not come as a surprise if these practices are detrimental to the economic interest of a particular sovereign nation. Calorimis’ affirmation that Protectionism will likely disappear once it becomes clear that it undermines the global market share of the protected countries’[21] banks cannot be considered in its full scope. Especially after the sub-prime mortgage crisis hit the US in 2008 causing a general systemic risk that permeated across the international banking and financial spectrum. Certainly, this caught many national and international regulators by surprise. Yet there were many signposts and many missed opportunities. Some commentators, including General Accounting Office (GAO) Comptroller, David Walker, pointed out the negative influence of the ballooning $56 trillion US deficit;[22] and the $50-$60 trillion size of the US unregistered market, which grew exponentially thanks to credit default swaps (CDS) and collateralized debt obligations (CDO).[23]
Others such as the Bank of Spain were more steadfast and had already positioned to spare the Spanish banking and financial sector from the potential of US toxic ‘financial innovation’ as early as 2000, and moved once more, quickly in early 2008 to penalize mortgage concessions over 95% loan-to-value (LTV) positioning itself to curtail a projected increase in delinquent loans and also liberate some resources. Unfortunately, the current government adminstration in Spain, led by President Rodriguez Zapatero since 2004, has been utterly incompetent in handling a crisis which it first refused to accept; now it is gradually spiralling out of anyones control. In late 2008, Spanish Central Bank Chief, Miguel Angel Fernandez Ordonez acknowledged the ‘lack of confidence [in the Executive] is total, consumers are not comsuming, employers are not hiring, entepreneurs are not investing and banks are not lending…‘[24] and yet despite the Central Bank’s prestige, the PSOE government is questioning the regulator’s independence and that of its Chief, pitting both against PSOE backed labor unions UGT and CC.OO., while several former socialist heavyweights along with opposition leaders claim, as does the Spanish Central Bank, a reform of the labor market is imperative to maintain Spain’s diminishing competitive advantage. When credit rating agency Moody’s downgraded numerous Spanish Banks, the Zapatero government attacked Moody’s credibility, as it failed to predict the real estate and financial crisis in both the US and Spain. In this regard, Henry George’s 1879 thesis regarding speculation in land value and its impact over the rest of the financial system’s balance in Progress and Poverty… the Remedy, is still valid and telling today providing a sound explation for the roots of the real estate and overall financial debacle.[25] With unemployment projected to hit over 20% in 2010 and with calls, even from within the EU and the IMF, to revise Spain’s 2010 General Budget into a more comprehensive one, President Zapatero refuses to listen as a greater social malaise tears apart Spain’s social fabric as well as its sovereign integrity. The outlook has clearly worsened for Spain as it positions for EU Presidency at the beginning of 2010, when potential increases to EU Central Bank interest rates could punish further Spanish financial markets and overall economy.
It is hoped by many, these signposts and missed opportunities may now be heeded under the aegis of a renewed US and international banking and finance regulatory framework in the next G20 meetings to cope with the global financial melt-down even as experts anticipate a slow real recovery.
[1] George J. Benson,
The Separation of Commercial and Investment Banking: the Glass-Steagall Act Revisited & Reconsidered (London, UK: The MacMillan Press Ltd., in association with the Dept. of Banking and Finance, City University Business School, 1990), p. 1
[2] Ibid, p. 41
[3] Lawrence S. Ritter, William L. Silber & Gregory F. Udell, Principles of Money, Banking & Financial Markets (New York: Addison Wesley, 2000) p. 303
[4] Ibid, p. 234
[5] Ibid, p. 303
[6] Regulation Q imposed interest rate ceilings which meant bank depositors could not get competitive market rates on their money. This circumstance propelled the rise of money market mutual funds, free to offer competitive market interest rates.
[7] Ibid, p. 205
[8] Ibid, p 208
[9] Ritter, Silber & Udell (2000), p. 303
[10] Alan Greenspan, ‘Subsidies & Powers in Commercial Banking’ in Proceedings of the 26th Annual Conference on Bank Structure & Competition (Chicago: Federal Reserve Bank of Chicago, 1990), p. 5 in Charles W. Calorimis, US Bank Deregulation in Historical Perspective (Cambridge: Cambridge University Press, 2000), p. 339
[11] Charles W. Calorimis, US Bank Deregulation in Historical Perspective (Cambridge: Cambridge University Press, 2000), p. 344
[12] Ibid, p. 347; See, e.g., ‘Europe’s banks Boost Plans for US-Style Loans Market’ Financial Times (July 28, 1997), p. 16
[13] G10 countries is composed of those 13 wealthiest countries by per-capita income.
[14] Kern Alexander, Rahul Dhumale & John Eatwell, Global Governance of Financial Systems: International Regulation of Systemic Risk (Oxford: Oxford University Press, 2006), p. 134
[15] Miguel Angel Noceda, ‘Ni Greenspan, ni el FMI, ni el BCE han funcionado bien’, El País (October 19, 2008) http://www.elpais.com/articulo/economia/Greenspan/FMI/BCE/han/funcionado/bien/elpepueco/20081019elpepieco_6/Tes (Last accessed November 4, 2008)
[16] Gillian Tett, ‘Time for central bankers to take Spanish lessons’, Financial Times (September 30, 2008), http://www.ft.com/cms/s/0/77409482-8e87-11dd-9b46-0000779fd18c.html (Last accessed November 4, 2008)
[17] ‘Spanish Steps’, International Banking Special Report, The Economist (May 15th, 2008), http://www.economist.com/specialreports/displaystory.cfm?story_id=11325484 (Last accessed November 5, 2008)
[18] Ibid
[19] See, Kern Alexander, Rahul Dhumale & John Eatwell, Global Governance of Financial Systems: International Regulation of Systemic Risk (Oxford: Oxford University Press, 2006), p. 50-51
[20] Ibid, p. 54
[21] Charles W. Calorimis, US Bank Deregulation in Historical Perspective (Cambridge: Cambridge University Press, 2000), p. 347
[22] David Walker ‘Interview with Bill Maher’, The Bill Maher Show (October 2008)
[23] CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. CDS contracts have been compared to insurance, because the buyer pays a premium, and in return receives a sum of money if a specified event occurs. However, this is a slightly misleading comparison because the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event; see http://en.wikipedia.org/wiki/Credit_default_swap; CDOs are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided by the ratings firms that assess their value into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. Since 1987, CDOs have become an important funding vehicle for fixed-income assets; see http://en.wikipedia.org/wiki/Collateralized_debt_obligation
[24] Miguel Angel Fernandez Ordonez interview ‘La desconfianza es total’, El Pais (December 21, 2008), http://www.elpais.com/articulo/economia/desconfianza/total/elpepueco/20081221elpepieco_1/Tes (last accessed October 18, 2009)
[25] Henry George, Progress & Poverty: An Inquiry into the Cause of Industrial Depressions & of Increase of Want with Increase of Wealth… the Remedy, 3rd Ed. (New York: Robert Schalkenbach Foundation, 1992)
