More regulation of banks and markets?

The general call for more regulation of banks and other financial service firms makes popular political good sense. But, can we refine this better before losing sight of the wood for the trees? Regulation of banking risks has been codified in law by Basel II, which sadly was not yet completed by banks ahead of the credit crunch. What this sought to achieve was assurance that banks have a thorough risk culture and risk accounting that could be periodically audited. Much more important. However, was to ensure that banks manage their affairs fully cognizant of economic cycles and their accompanying credit cycles. This has proved to be horrendously difficult. The academic literature is rich in credit risk models, but very poor in models of how banks can or should relate their balance sheet experience to the surrounding economy.
Matters have not been helped by the political idea that gain much currency in the US and the UK that governments could and should manage their economies so as to banish economic cycles, an idea that had no credible (empirical) academic support at all. It was certainly not an idea believed in by central banks and financial regulators who worried mightily and warned about the risk that if banks protected their own balance sheets by anticipating credit cycles, they would thereby amplify economic cycles; higher asset bubble peaks followed by deeper longer-lasting troughs! In fact this is very much what we are now experiencing; recession led by the finance sector (because some sector spokes must be out front as cycles turn, while other macro-factors ought not to be ignored such as the extreme external account imbalances of recent years and how these were financed).
But, the behaviour of banks does not create markets so much as markets dictate how banks behave. Regulating all banks is therefore not enough. While the regulation of banks has progressed and become very sophisticated under the global auspices of the BIS, the same cannot at all be said for wholesale financial markets. There has been a massive dis-intermediation of stock markets such that the regulated quality of stock markets has been shredded and debate about the quality of price discovery (the complex question of how to ensure that prices reflect fair value) has been lost in the drive to lower transaction costs and allow a plethora of alternative trading networks, both internal and external to brokers and institutional investors.
Instead of FX, money market and bonds and all their derivatives being brought on exchange and under regulatory oversight, equities trading has been shifted by privatization and liberalization to the equivalent of over-the-counter trading, dark pools etc. More regulation has to begin with how the quality of markets are regulated.

Investors and many traders are unaware or neglectful of the regulatory qualities of markets, merely happy to arbitrage via ever faster transaction processing. They assume that if a market is big enough with major players involved then it must be known, understood and regulated, but this has been palpaly less and less so. The credit markets appeared regular, but fundamentally disorderly and illiquid in secondary trading, incapable of managing downturns.
My point therefore, is that further regulation needs to begin with how to regulate the financial markets.
The equivalent agency to BIS for this is the FIBV, the association of the world’s stock exchanges. But, their power is limited beyond statistical reporting of capitalizations, plus whatever they can manage in tracking trading volumes and basic standards.
Exchanges failed to stop black box algorithmic trading and the massive growth in intra-day trading that has been key to short selling and other disorderly activities.
They have had no political backing to insist on more or all fixed income trading being brought on exchange, for example, and into regulated clearing houses. There is no exchange or regular reporting for the world’s FX or money market trading. FIBV’s power to implement risk management rules and laws are not those of BIS.
Europe’s MiFid regulation intended to make it easier to trade securities across borders and sweep away the dominance of national exchanges and their regulators has weakened regulation further, albeit at substantial bureaucratic cost to banks and brokerages. Seven years in the making, MiFID was designed to facilitate a single EU-wide market for financial services, but not one that could be overseen and have its quality routinely checked. The directive met resistance in Italy, France and Spain, as governments fretted that their capital markets and regulators would lose influence – quite right.
We can now see the consequences of credit markets acting with as little policing as gold rush towns in the Wild West. The trend towards increasing liberalization will now reverse. Over-the-counter markets will have to be dragged on-exchange. These may be national or regional and by currency zone or timezone, but there must be government backed regulatory oversight.