£20bn

Estimated amount lost by Northern Rock

Financial regulators and senior bankers want to repair the damage done by the credit crunch. But can they get the industry out of a mess that they helped to create?

Some observers seem to think the credit crunch is over. The turmoil in the global financial markets had, by this Spring, showed signs of calming down. All the big banks had come clean about the damage they had managed to inflict on their balance sheets. It was time to move on, they said.

As we report elsewhere in this edition, that’s a rosy view indeed. The financial industry may be claiming it is business as usual, but for other sectors, and for people living in the developed economies, the pain is only just beginning. The fallout from the financial crisis is going to rain down on their heads for a long time to come.

Banks aren’t going to escape without further suffering either. They may have disclosed their immediate losses. Next they need to digest the inevitable mass redundancies, as they rethink their business models and try to get back to a more realistic appetite for risk – and reward.

Mervyn King, governor of the Bank of England, has been among those handing out hair shirts. He recently told a committee of the UK parliament that a big-bonus culture was to blame for the banking crisis. The promise of huge rewards had tempted people to take excessive risks. King said it was “unattractive” that so many young people thought the City was the best place to work, thanks to its inflated pay packages.

The notion of the governor criticising big payouts would have been unthinkable not long ago. The City of London likes to describe itself as the centre of the global financial services business. Pushing its virtues has been a big part of King’s job. Previously, the City’s leaders would have laughed off complaints about high pay as naïve. Not now. King wants to see a cultural shift. To what? The answer is not clear.

He also put the boot into the US banks that sold sub-prime mortgages in the first place. It would be a “charitable interpretation” to say they were miss-sold, he said. As for the wider market in mortgage-backed securities, King said such instruments had no future if the value of the underlying assets on which they were based was too vague. “They may have looked clever but actually they were based on some poor assumptions,” he told the committee.

The irony in all this should be clear: where’s the admission of regulatory failure? In the UK, the Bank of England has been roundly criticised for its botched handling of the country’s biggest credit crunch casualty, Northern Rock. The retail bank collapsed into state ownership, owing the taxpayer over £20bn, when the lack of wholesale funding trashed its business model. Along with the Financial Services Authority, and the government, King’s Bank of England is responsible for regulating firms like Northern Rock and ensuring the banking system runs smoothly. All three failed, and all three are squabbling about who was to blame and how they can provide better supervision in future. In the meantime, the Bank of England has tried to shore up confidence with a scheme to swap dodgy bank debt for short-term loans – a scheme that could involve £50bn of public money.

This irony has not been lost on the City. The British Bankers’ Association leapt to defend its members, saying King should avoid wading into a row over bonuses. “This is a financial services industry on which a lot of jobs are hanging; I don't think we should have the luxury of public squabbles,” said BBA chief executive Angela Knight. Off the record bankers told the Independent newspaper that King’s comments were “back-covering” and a “giant red herring”. It quoted one who said: “He is just trying to deflect attention from the central bank during a difficult time for the markets, and he is also trying to look tough. Bankers won't really care about the comments.”

Even other central bankers have been critical of the Bank of England. It made a mistake last year because it didn’t pump enough extra funding into money markets at the height of the credit crunch crisis, German Finance Minister Peer Steinbrueck said recently. Steinbrueck praised the US and euro zone central banks’ approach to helping commercial banks through the credit squeeze. Their policy was right, he said, before adding: “A bank that didn't do this in Great Britain led to people standing in long queues” – a reference to the images of anxious Northern Rock customers who lined up to withdraw their deposits.

It’s not just the Bank of England that messed up over Northern Rock. The poverty of the FSA’s supervision of the bank was made clear by its own internal auditors. Their independent report into the way it regulated the firm, a summary of which the FSA has published, describes a litany of failings. The turnover of staff supervising the bank, for example, was too high. In three years there were three heads of department responsible for Northern Rock, with the only continuous supervision coming from a manager and lead associate – fairly lowly staff. Record keeping was sloppy.

Contrary to FSA norms, there were no written notes of key supervisory meetings with Northern Rock. The FSA failed to require action from the bank after its 2006 risk assessment visit. And the FSA’s own line managers failed to spot any of these supervisory weaknesses, which is an extraordinary failing. If the FSA found a regulated firm operating with such poor management oversight and such weak systems and controls it would shut it down without thinking twice.

The Northern Rock fiasco is indicative of wider problems. The FSA’s internal auditors, as part of their review, also looked at how well the FSA was regulating other banks. They found that its supervision of Northern Rock was “at the extreme end of the spectrum” – a carefully crafted euphemism if ever there was one. Nevertheless, the impact of the credit crunch on financial firms does bring the quality and effectiveness of regulation into question.

Regulators such as the FSA, the Bank of England and those in other developed countries need to justify themselves. Not only are they expensive to run; their work puts a costly compliance burden on the firms they regulate. Given how much focus they have put on the importance of risk management, internal control and corporate governance, one would expect the firms they regulate to perform well in these areas. The credit crunch has proved that they do not.

Two recent reports have highlighted just how bad financial firms, internationally, are when it comes to risk management, for example. The Financial Stability Forum, a grouping of central bankers, published a report on the credit crunch in mid-April. It made damning reading for the financial services industry and pointed to a colossal failure of risk management by the industry as a whole. “Some of the standard risk management tools used by financial firms are not suited to estimating the scale of potential losses in the adverse tail of risk distributions for structured credit products,” the report noted. “Market participants severely underestimated default risks, concentration risks, market risks and liquidity risks ... a number of banks had weak controls over balance sheet growth and over off-balance sheet risks, as well as inadequate communication and aggregation across business lines and functions.”

In today’s climate, this conclusion comes as no surprise. But it would have done this time last year. A claim that, despite all their supposed excellence at managing risk, firms were failing so badly, would have been barely credible. Banks around the world have spent years investing in their risk management capabilities. The Basel II banking according gave valuable business incentives to those who could demonstrate that they had achieved best practice in this area. Many had convinced their regulators that they were so good at risk management that they were allowed to use their own models to calculate how much capital to set aside against risk. The crude percentage measures of old were only for those laggards who could not achieve what Basel II required.

The fact that these models failed, that their enormous complexity did nothing more than hide their utter fallibility, will cast a long shadow over the financial industry. It needs to completely rethink its approach to risk management, going right back to basics, if it is ever to regain trust and credibility.

But there must be doubts over whether those currently leading the industry are capable of this task. Can the people who created such a mess really lead their firms out of it? As a recent report from the Institute of International Finance noted, current events “have raised questions about the ability of certain [bank] boards properly to oversee senior managements and to understand and monitor the business”. 

Josef Ackermann, chairman of the IIF’s board of directors, and chairman of the Deutsche Bank, remains optimistic. The report “underlines the fact that the leadership of our industry recognises its own responsibility to restore confidence in the financial markets, solve the problems that have arisen and prevent those problems from recurring in the future,” he said recently. “We are fully committed to raising standards and improving best practices in the financial services industry.”

Accepting that it’s your responsibility to fix a problem and being committed to doing something about it is one thing; actually being up to the job is something else. Ackermann, for example, has led Deutsche Bank into its first quarterly loss in five years, after $4bn in writedowns. It made a €3bn profit for the same period a year earlier and had been predicting to make €8.4bn for the full year. Not any more.

The IIF report makes it clear that financial firms need to change fundamentally. Many in the industry have pointed the finger at mark-to-market accounting rules. They claim that the requirement to take an immediate write-down on falling investments has exacerbated the crisis, and made them report “losses” that are likely to return to profits when the markets stabilise. The IIF report blames these rules too. But their contribution should not be overestimated. A deeper contributor to the crisis is the toxic risk culture that exists within many firms.

Senior managers and boards were warned by their own risk management experts that the wrong trading or lending decisions were being made. But these “aggressive risk-taking decisions” were not stopped, the IIF report says. Essentially, in their arrogance, the bankers thought the risk experts could be ignored. They were wrong, and have said they will put things right. In the meantime, their mistakes have pushed the global economy to the brink of recession: everyone will have to pay the price for their hubris.