The Regulatory Big Picture

Amid extraordinary scenes - the failure of Lehman, the purchase of Merrill, a $85B FED line to AIG (albeit it at L + 850) - it is appropriate to consider the big questions that face the Americans.

Firstly, note that the FED has acted, but that what it has done is very much policy making on the fly. Suspension of Section 23a of the Federal Reserve Act, for instance, may well be illegal. And in the AIG support, the FED is off the edge of the US regulatory map. The politicians want to get involved, and in due course they will.

So what are the questions?

Firstly, is there any role left for separately regulated broker/dealers? My sense chimes with the majority opinion that the answer to that is no. With 2 big clients left out of 5 at the start of the year, the SEC (and specifically its capital regime) does not emerge covered in glory. How should the broker/dealers be supervised going forward?

Secondly the insolvency regime for financials needs to be addressed urgently, in the UK just as much as the US. In particular exactly when can the regulator seize the vehicle, what happens to the holders of subordinated claims at that point, how derivatives claims (with their effectively supersenior definitions of termination events) interact with that, and the issues involved in making cross border insolvency fair need to be thought about hard.

Thirdly and perhaps even more controversially, what about insurers? US state insurance regulation is complex, capital requirements for financial risk are simplistic, and the US regime has not come out of the Crunch looking good. Think of the monolines as well as AIG. I am not sure the European answer is much better, but at least Solvency 2 is an attempt to address the issues.

Finally, a lot boils down to leverage. Capital rules were supposed to constrain leverage. They didn't, thanks to numerous failings. Free passes to SIVs and conduits, the lack of capital for liquidity risk, VAR based market risk capital which ignored fat tails, capital based on rating, the Basel 2 treatment of residential property: all of these were gross failures of regulatory prudence. It is, I fear - and I know how many careers this would threaten and how unlikely as a result it is to happen - time to throw away Basel 2 and start again. We need a set of capital rules which are appropriate for a wide diversity of risk taking, from AIG FP through Cheyne Finance and MBIA to Lehman Brothers (R.I.P.) and on to traditional banks like Santander. They need to be anti-cyclical, and they need to be fair. That means no grossly preferred asset classes, accounting methods, nor ways of taking risk. It is a big job, but it desperately needs doing. Whither Basel 3?