31 March 2015

Can financial markets be controlled?

Howard Davies
2014, Polity Press, 136 pages, £6.99
ISBN 9780745688312

Reviewer: Kitty Ussher, Managing Director, Tooley Street Research

The ostensible purpose of this slim and accessible volume by Howard Davies is to express his concern that regulators now “appear to be acting as shadow directors” of private sector banks.

He sets out two possible regulatory responses to the financial crisis. The first is to strengthen the control mechanisms within firms – primarily through tough countercyclical capital requirements but also living wills, greater reliance on equity finance, and corporate governance reforms – so allowing firms to succeed or fail based on their business strategies, with social risk minimised at the expense of shareholder risk. The second is a more tightly controlled regime where key judgements on risk management, appointments and remuneration are made by nervous regulators who hence become, “More and more closely implicated in management decisions.”


The book’s thesis is that the two are incompatible, that the second scenario appears “more likely at present” and that this is a problem because, “Detailed intrusive regulation is doomed to fail.” Hence it is time to wake up to the fact that the answer to the question posed by the title of the book is a resounding no.

So what then should be done? Top of Davies’ list is to legislate for a WTO for the financial sector, perhaps building on the Financial Stability Board, to enforce consistent accounting standards, solutions to the cross-border aspects of living wills and too-big-to-fail resolution issues and set capital and other requirements that are internationally consistent to prevent regulatory arbitrage.

The tax treatment of equity should be aligned with that of debt (or alternatively, banks should be taxed on their liabilities) in order to promote healthier balance sheets and shift more risk onto shareholders. Central banks need “a targeted interest rate which only applies to housing credit” and should “speak truth unto power” for example regarding policies designed to increase home ownership. En passant he refreshingly states it was “not self-evident” that the FSA needed abolishing, queries the existence of moral hazard in the decision making of failing banks and on Glass-Steagall finds it, “Hard to point to failures that are attributable to its abolition.”

The book is structured in four 25-page chapters, the last of which could hold its own as a separate essay. The preceding three contain a thoughtful summary of the causes and responses to the crash, employing a motorway analogy to separate out the hazardous driving conditions from the (separate) decisions of some firms to put their foot on the accelerator. The bibliography is especially useful, representing as it does Howard Davies’ considered view of the most important contributions to recent economic history.

Not everyone will agree with everything Personally I took issue with a statements that countries with larger financial services sectors had worse recessions, that a cross-border euro-area deposit protection scheme is a necessary outcome of a single currency, and perhaps predictably with his assertion that the Treasury had not imposed a clear policy line within the Tripartite system. But taken as a whole this is a timely, intelligent and useful reflection on the current debate from someone well placed to comment.