This article originally appeared in the online edition of InvestmentNews on 9 September 2012.
In the immediate aftershock of the financial crisis, we found ourselves in the “new normal” of a lackluster and uneven economic recovery resulting from the combined forces of deleveraging, regulation and deglobalization.
These forces continue to play out in much of the global economy, particularly in the developed world.
Recent trading losses and allegations of improper activities by major commercial banks – and the regulatory fallout – remind us that the financial system is yet to heal, even as we approach the fourth anniversary of the spectacular collapse of Lehman Brothers Holdings Inc.
The paradox faced by regulators is acute: They may not be helping to heal the global economy's wounds and in some instances may even be exacerbating them.
On one hand, global central banks are using unconventional monetary policy extensively. In the United States, this includes a commitment to maintaining exceptionally low interest rates far into the future, so-called quantitative easing and maturity extension programs, in which central banks buy longer-term government debt to drive down long rates.
Policies starting to work
Elsewhere, particularly in the stronger European creditor countries, policy and risk aversion have contributed to more instances of negative nominal interest rates on government bonds.
The intended purpose of these extraordinary efforts by central banks is to push the expected return on risk-free investments so low as to force banks to lend and to entice investors to put money into risky assets. That would increase the availability and reduce the cost of borrowing to the real economy. Yet a stunning $1.5 trillion in excess reserves sit idle on bank balance sheets, earning a mere 0.25% overnight at the Federal Reserve.
The ability and willingness of banks to unlock reserves and lend to consumers and businesses, large and small, would be important contributors to a sustainable expansion.
Evidence exists both on the economic front and from a market perspective that central bank actions are having an effect: Banks have relaxed lending standards, as reported in the Federal Reserve Senior Loan Officer Lending Survey. Investors are starting to display a greater risk appetite, with $28.1 billion flowing into high-yield mutual funds alone so far this year, almost double the amount seen in all of 2011.
At the same time, tightening action from regulators that sometimes give mixed signals may be prompting unnecessary volatility and having a deleterious effect on lending.
The most recent example is an action by the New York State Department of Financial Services against Standard Chartered Bank Ltd. In an Aug. 6 lawsuit, the regulator alleged that the bank “schemed with the government of Iran and hid from regulators roughly 60,000 secret transactions, involving at least $250 billion.”
Just over a week after the suit was filed, the regulator and the bank announced a $340 million settlement. It seems incongruous to observers that a claim of rogue activity involving such a large sum should translate into a relatively meager settlement in such a short time.
Meanwhile, Standard Chartered's stock fell by more than 30% from its recent high, and the risk spread on outstanding bonds rose by more than 1%.
The U.K. Financial Services Authority complained to the New York regulator that the lack of notice and coordination could have destabilized Standard Chartered.
Housing turnaround
The sector perhaps hit hardest by the crisis – housing – is showing signs of recovery, with growth in mortgage lending accelerating at a comfortable pace.
These are the green shoots of sustainable recovery, as opposed to the stop-start environment we have faced in recent years. These positive developments should be embraced and fostered.
Such hopeful signs notwithstanding, structural headwinds facing heavily indebted developed market economies require cooperation and coordination between banks and regulators. Acrimony and polarization only exacerbate the effects of a wounded economy.
Like risk management, regulation should focus on outcomes – always seeking to protect taxpayers from loss in negative scenarios while fostering an environment that is conducive to lending, economic expansion and positive scenarios.
What is needed is forward-looking regulation that can level the playing field between Wall Street and Main Street, create appropriate incentive structures and penalty functions, and protect people from predatory practices. To foster sustainable economic growth while balancing proper regulation, regulators, policymakers and the banking sector must work together in a spirit of cooperation.