According to a senior manager at a Bangladeshi bank, chatting over lunch at the Sibos conference in Amsterdam last week, Bangladeshi financial institutions escaped the impact of the financial crisis because the domestic banking regulator forbade investment in structured credit. This was not because the Bangladesh Bank was remarkably prescient about the eventual fate of CDOs; after all, the senior tranches were all dutifully rated triple-A by the agencies. It was because, it frankly confessed, it could not make head nor tail of these instruments and could thus provide no regulatory guidelines. Other regulators (not to mention rating agencies) must now wish that they had been so pragmatic. If they had, then the world might have been spared a lot of bother. As it is, global financial regulators are determined not to make the same mistake again. They are promising a wholly new approach to financial regulation and by their actions, they hope, ensure that a repeat performance of 2008, and anything else really bad, is avoided. US insurer AIG secured its enormous losses by taking large, unhedged and unregulated long positions on the CDO market by selling credit default swap protection. When the firm was bailed out it owed billions to major banks, which the bailout funds were used to honour.
In other words, taxpayer funds were channelled directly into the coffers of those institutions at the heart of the crisis. This sort of thing now serves as a stern corrective to regulators and guides their thinking. If anything, European regulators in private are more hawkish than they have so far been in public. What has been presented by rule-makers to banks may prove to be the thin end of a large wedge. For example, it is an open secret among those who speak to the regulators that a move to push an ever greater share of OTC derivatives on to exchanges is only a matter of when, not if. At the moment they are talking only of the salient importance of clearing houses, but this is seen as the preamble to a concerted campaign to mandate the use of exchanges for a wide range of OTC derivatives. While this is not exactly news for banks and many end-users, it is nonetheless depressing. The real battle will be fought over what instruments are deemed sufficiently standardised and therefore suitable for exchanges, and those that are not. In the meantime, however, regulators stress the value of and the imperative need to introduce clearing houses. Before the market stands the prospect of a sudden proliferation of central counterparties, each of which will incorporate significant amounts of risk and will be, presumably, too big to fail – just as the major banks were two years ago. Regulators often realise these potential frailties and shortcomings, but they will not be budged from their chosen path. “We realise the problems with clearing houses, but if anyone knows of a better answer please let me know. They are all we’ve got,” said one last week. If the problems associated with central counterparties do not act as a disincentive to the creation of a lot more of them, a different set of problems are unlikely to dissuade them from the advocacy of exchange trading. There is a sense of fatalism to be detected among derivatives bankers. They know regulation is coming, and are very worried about the spirit of anti-banker populism which animates it and the haste with which it will be implemented. Even when they acknowledge that new rules are inevitable, they wish that the regulators had been prepared to demolish redundant existing regulation before simply adding to the pile. But bankers also privately realise that they have to make the best of it, and that they really haven’t got a leg to stand on. Trust between the industry and the public and its elected representatives has been atomised. It would be naïve to expect regulators to do nothing in the wake of this. In fact, on some levels and among some bankers a new spirit of humility is perhaps detectable. This is not a quality often in great supply when dealing with investment bankers, but some of them realise that after the events of two years ago a defiant stance is not productive.
Derivatives bankers will claim that their instruments didn’t cause the meltdown, and in fact operated with great efficiency during the period of greatest stress, but no matter. They are part of an industry that failed on a vast scale, and however displeasing and often misinformed the widespread animus against bankers might be, they are going to have to ride it out. Simply asking to be trusted and for the whole bandwagon to start rolling again with assurances that a repeat performance of 2008 will not occur is not going to happen, and the more discerning bankers realise it. The end-of-conference grand party and shindig was back on the agenda at Sibos 2010. It was not held last year as it was feared it would summon unnecessary criticism. Indeed, this year, in the face of the prospect of double-dip recession and general economic despondency, the sight of 8,500 bankers at a late-night jolly in the City of Sin might not seem congruent. But this would not be fair to the changed spirit of the times; most bankers are aware they must wear sackcloth and ashes for a bit longer.