Risks to recovery from overzealous regulations

Central bankers in the US and UK recently proclaimed the end of the worst global recession since the Great Depression. However, Federal Reserve chairman Ben Bernanke and Bank of England governor Mervyn King have both acknowledged that any recovery will be slow and painful, with unemployment likely to rise for many months to come.

As the international economy begins to emerge from the depths of the crisis, regulators are increasingly adopting a more hands-on approach to ensure past failings are not repeated. This has provoked the debate about bankers’ bonuses and Lord Turner’s comments questioning the social value of parts of the financial services sector. Although it is easy to understand the sentiment behind any attempts to improve the regulatory structure, any reforms must be rigorously assessed and carefully targeted. For example, raising capital requirements and so-called living wills will reduce systemic risk, but also constrict the amount of bank lending to businesses and consumers. This may help to stop asset bubbles from emerging by limiting mortgage funding but also runs the risk of starving the housing market of funds leading to another downward spiral in prices. The consequences must be examined before any changes are implemented.

A failure to strike the right balance between allowing closely controlled financial innovation and protecting against systemic risk could stall the recovery, and that is why this week’s G20 meeting must set the agenda for globally co-ordinated reform, while also recognising that a “one size fits all” solution is impractical. Clearly, there needs to be flexibility across countries and regions, but a failure to co-ordinate regulation across different jurisdictions will benefit no-one. The threat is that countries put national self-interest first for short-term political gain, which would effectively turn regulation into a de facto form of protectionism.

World leaders must recognise businesses require certainty, clarity and consistency, and this is especially true in financial services, with City-based firms operating in an international under multiple regulatory agencies. Financial centres must work together to ensure regulation promotes the same outcomes. Improved levels of transparency, accountability and risk management are essential to restoring public confidence in the financial system.

Resolving these issues should be the focus of attention in Pittsburgh, and not headline-grabbing arguments about limiting bonuses and punishing bankers.