Why regulations are never a panacea

Allister Heath
ONE of the biggest problems with the financial system in the run-up to the financial crisis was insufficient liquidity, as well as insufficient capital. The difference between the two is crucially important: one might have plenty of capital reserves, but if these cannot be accessed then a crisis remains guaranteed (unless the central bank steps in). Many firms didn’t have enough easily sellable assets such as cash or government bonds; most thought that other assets such as CDOs would remain liquid; too many relied on huge amounts of short-term money market borrowing, which they thought they would always be able to roll over easily. When spooked markets suddenly froze, they very soon ran out of liquidity.

In part, this was due to a giant intellectual error: mainstream academics, regulators and practitioners assumed that markets would always be “complete”, that there would always be a rational market for every kind of asset at all times and that therefore the market price for everything was also always the correct price. I exaggerate slightly, but not much – and the accountants also jumped onto that insane bandwagon, stipulating that firms should mark assets to market. When liquidity dried up, asset prices collapsed and institutions made massive write-offs, forcing bankruptcy. It was the economics of the madhouse – incorrect assumptions about liquidity feeding into incorrect assumptions about capital.

The Basel meeting was primarily concerned with capital ratios but it also announced a new liquidity coverage ratio. Many firms have already built up liquidity in anticipation by holding more gilts. What I find deeply worrying is that the Basel deal assumes that government securities included in the regulators’ definition of liquid assets will always be highly liquid. Really? What about Greek debt? We are back in the fantasy land of mainstream finance theory, whereby government bonds are assumed to be risk-free, almost by definition.

Forcing banks worldwide to buy vast amounts of government securities may also help fuel another bubble, similar to that triggered by the Chinese, Japanese and Mid Eastern investors who bought over $1 trillion (£650bn) in US debt in the run up to the crisis. This bid up the price of debt, pushed down yields and put downwards pressure on long-term interest rates globally, prompting a tidal wave of cheap credit. As I said yesterday, Basel III is primarily a good thing – but it is hardly a panacea.


I’m delighted to be able to invite all readers of this newspaper who are interested in trading foreign exchange to a free seminar, the first of a new series of events City A.M. will be hosting. Our first seminar, co-hosted by GFT Global Markets, will be held on Thursday 23 September at the Grange Hotel, St Paul’s, from 8am to 10am.

I will be in the chair, share a few thoughts on the economy and introduce our brilliant columnist Boris Schlossberg, GFT’s director of currency research and one of America’s foremost retail forex experts. Schlossberg will be explaining where the dollar is headed as 2010 comes to an end. We will then discuss three simple strategies for day trading forex; and an expert will conduct a demo of some state-of-the-art trading software.

I hope to meet many of you on 23 September; anybody interested should register at www.gftuk.com/cityam as soon as possible.