Bank regulation

Alasdair Macleod – 30 March 2011

The regulation of banks simply does not work and has led to a serious loss of public credibility in them and of confidence in their true motives. Almost all of the problems arise from their activities in securities markets, rather than traditional banking. The conflicts of interest and profitability of these fee-earning and trading activities have been growing, dwarfing the importance of normal banking income. These factors are irreconcilable, and a sensible unregulated business would have decided long ago where its true priorities lie, so that they may focus on them by ceasing any conflicting activities.

Government-sponsored regulation therefore fundamentally alters the competitive picture by legitimising the natural desire of banks to maximise their financial power, rather than compete in a free market for customer business. In this sense, the regulator has become the tool of the monopolistic banks, because the regulator is the path to that power.

The relationship is always presented the other way round. A good example of this occurred last year, when JP Morgan Securities Ltd in London was fined $33.32m by the Financial Services Authority for co-mingling segregated client funds with the parent bank’s assets.

This is extremely easy for a bank to do, deliberately or unwittingly. The JPMSL case involved client money held in connection with futures and options business over a seven year period, and the balances fluctuated between $1.9bn and $23bn. These balances were deposited with JPMSL’s parent, JPMorgan Chase Bank, so in the event of JPMCB going bust, segregated client funds would become the property of the liquidator. According to the FSA statement this “error” was not deliberate, and was “self-reported”. The implication is that regulation works so well that even a major banking organisation confesses to regulatory breaches that might otherwise have gone undetected.

If the law had not been changed in the first place to accommodate the role of the FSA and the legal status of its regulations, the error would arguably have been criminal. The confusion initially arises from the benefits conferred on a bank by its license, which allows a bank to take someone else’s property onto its own books and use it for its own benefit. Anyone who does this without a banking licence clearly commits fraud, and this must also apply when a bank offers non-banking services, because its customers by definition are not in a banking relationship. JPMCB’s compliance department should have been alive to this possibility when JPM merged with Chase Bank, which is when the problem first arose. And the management of JPMSL’s futures and options business should have thought through the implications for their customers, rather than not thinking at all.

But the question that jumps out from this episode is why did the FSA itself not detect this gross breach in any of its routine and ad-hoc inspections from December 2002 onwards, when the breach first occurred? The first thought in an inspector’s mind should be to examine all possible conflicts of interest arising between a subsidiary and its parent. Furthermore, all regulated entities make periodic returns, so any deposits from separately licensed subsidiaries should be apparent and therefore questioned. And while failing in their stated duties the FSA employs 4,000 full-time staff on an annual budget of £500m.

The answer is that the regulator is primarily a government bureaucracy, and only secondly a watch-dog for the protection of market participants: the priorities are firmly in that order. There is no mechanism for placing a value on the FSA’s role, so it cannot be otherwise. As such, the FSA can never do its job satisfactorily, and it will always manage itself in order to satisfy its own priorities ahead of those of the public. To demonstrate that it is actually doing the opposite, the FSA relies on an enormous and complex rule book, with the result that regulated businesses are required only to comply with it. Any other business considerations, such as a primary duty to the customer, come a poor second. Thus, the creation of a regulatory bureaucracy, responsible primarily to the political elite and the powerful banks rather than the markets, has played a large part in the destruction of traditional business ethics in the UK’s financial sector.

It is perhaps ironic that the FSA is unable to understand its own limitations, but joins in attempts to limit super-regulation from Europe. The FSA can grasp the political intent from Berlin and Paris to limit London’s role as a competitive financial centre, but fails to see the damage it has wreaked itself at the behest of British politicians. However, the inability of regulators to discharge their allotted functions is also evident in America.

The US Commodity Futures and Trading Commission was established to regulate futures and options markets. But the same rules apply: the CTFC’s primary responsibility is to the political elite that created it and its own organisation rather than to the market itself, which is a secondary consideration in common with all government-sponsored regulators.

The result is the CTFC does not have a free hand in policing the market and controlling systemic risks, which, if the role of the CTFC could be valued, is what the users of the market would probably require. Even though the CTFC has just closed a public consultation period where it has sought the views of all market participants, it will only enact those changes that do not conflict with the interests of the powerful vested interests that govern it. So the wider users of the market who expect unbiased results will again be most probably disappointed.

The relationship between regulators and the powerful monopolist banks has become one of servants and masters respectively. The CTFC has recently rubber-stamped an application by JPMorgan to operate a Comex/Nymex precious metals storage vault, in a fraction of the time usually taken for such an authorisation. One is left wondering whether the speed of processing the application reflects the desires of the CTFC’s true masters. But, as Mark Anthony said of Brutus & Co., “They are all, all honourable men.” The power of JPMorgan and its long-running short position in silver make us vulgar mortals intensely suspicious of their motives. Can we really assume that they will use the facility honestly for their customers, and never for their own ends?

The granting of this precious metals depository licence follows the opening of JPM’s precious metal storage facility in Singapore and its announcement that that it is prepared to accept gold as loan collateral. On the face of it, JPM’s management have decided that precious metals will continue to be a growing business for JPM’s customers for years to come. But anyone depositing gold with JPM as collateral should be careful that the loan agreement stipulates it is held separately by JPM as custodian, and the same identified bars are to be returned at the end of the loan.

But hey, friends, Romans and countrymen, perhaps this caution is undue, because JPM’s management are all, all honourable men. And remember, while you may end up out of pocket, those regulatory boxes will have been well and truly ticked.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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