International Banking Regulation, Squaring the Circle? by Hans Bernd Schaefer

My first job was to work for the management of a large German bank in Frankfurt, which for the right reasons does not exist any more. What I learned on the job was basically how to circumvent regulatory laws and the control of auditors.

At the time regulatory laws prohibited to lend more than a particular quota of equity capital to one debtor to avoid the concentration of risk. This rule was not more than a joke. The bank was grossly overexposed to an Asian government and received a higher interest for those credits. It established a subsidiary in Liechtenstein, which in Liechtenstein was not a bank but an ordinary and unregulated business. It lent money to this subsidiary, which again lent it to the Asian state. Thus the balance sheet was kept clean and the auditor made his check mark.

The bank had a subsidiary, which specialized in giving risky credits to foreign debtors. When I was there, it became clear that this subsidiary had accumulated a dangerously high amount of foul credits. Several of our team had nothing to do than to telephone and travel around the world to save a least part of them. On staff meetings this was a never ending but secret story.
A little later the bank sold this subsidiary to another German bank. For this purpose the subsidiary set up a balance sheet, approved by a large auditing firm. In this financial statement the foul credits appeared with their face value. The auditing firm had not gone through the files carefully enough to see that a foul apple was to be passed on to somebody else. The sold bank went bankrupt a year later and the CEO, who thought he had bought it for a bargain price was fired. The CEO who had sold it as well as the auditing firm had nothing to fear.

When my bank itself set up its balance sheet, it turned out that the profits were a bit low and that the owners would like to see higher profits. No problem. Another subsidiary was established, a real estate company, which bought estate from the bank at an overvalued price. Thus an additional nice profit showed up in the balance sheet and again the auditors accepted this as long as the overvaluation was not scandalously high. By the way, this and other, similar methods are used by managers, whose salaries exist in large parts of bonus payments.

Such practices played a big role in the global financial meltdown. And you can see how difficult it will be to regulate this internationally. It is even questionable, whether this is possible at all.

Financial regulatory agencies get sometimes captured by bank interests as well as by ideology. The IMF has played a disastrous role for many developing countries and countries in transition. Its mantra of “privatise, liberalise and stabilise”, the policy of the so called “Washington Consensus” has led to stagnation in Latin America and to collapse in Russia, because it overlooked the importance of institutions for a market economy. (See the writings of Acemoglu, Rodrick and others). Empirical studies (Frankel, Roubini) about IMF lending have revealed that the facts support better the bailout hypothesis than the stabilisation hypothesis. In other words, it is more likely that these credits were used to bail out banks, especially US banks than to stabilise the debtor countries. Should the IMF be trusted to oversee the world financial system for the benefit of the ordinary taxpayer? I have doubts. To reform large organisations is as difficult as to reform political parties or churches.

Assume that the problem of regulatory capture can be successfully solved. An international regulatory agency must have access to all financial data worldwide. Is this transparency at all possible? It might be possible to eliminate some white spots on the financial landscape for instance in Switzerland, Iceland or Estonia. But the main problem is not these unregulated havens, it is China. China has become the most important player in the world financial markets with foreign reserves of over 1.7 trillion dollars and a current account surplus of more than 370 billion dollars in 2008. Does anyone believe that the Chinese government will let an international regulatory agency look into its deck of cards? Chinese banks are state controlled and state owned. The government uses them to steer the economy and to make politics. China is a nation with a long standing tradition of secrecy. Its most fabulous monument is the “forbidden city”. Another important financial player is Saudi Arabia. Does anyone really believe that these two countries will open all of their books to international controllers?

A third question mark goes to the auditors. The scandals and omissions, in which they are involved and which they did not prevent have accumulated so much, that some people start asking, whether this profession is of any use at all. Here at least something can be done, sharpen the liability of auditors. I have proposed this in several articles before. So far liability does not work. Courts are reluctant to define due levels of care, which are different from those, which the auditors have defined for themselves. And courts set very and in my view unreasonably high hurdles for the proof of causation. In other words, courts prefer to make type-one-errors over making type-two-errors. They should and could strike the balance between both types of error better.