Structural Complexity in the Banking System

When Northern Rock started falling apart, it prompted people like accountant Richard Murphy to start taking a detailed look at its borrowing structure. Like all banks, Northern Rock structured a very complex series of bankruptcy-remote special-purpose vehicles to do its borrowing for it. And it turns out that the beneficial owner of one of those SPVs, Granite Master Issuer PLC, is a charity, the Down’s Syndrome Association North East (UK). Not that the charity knows anything about it:

In connection with the current problems of Northern Rock, we would like to assure our members and supporters that Down’s Syndrome North East (DSNE) has not been knowingly involved in any misuse of money. We are investigating why our charity appears to have been named as a beneficiary of a Trust without our consent. We have definitely not received any money from Northern Rock or affiliated companies, except for a one-off donation from a staff collection in 2001.

The disussion on Murphy's website is fascinating, pitting finance-world sophisticates against people who are shocked at the opacity and complexity underlying something as fundamental as banking and mortgages. Not to mention the fact that a charity was used, without its consent and for no consideration, so that the bank's funding vehicle could have tax-free status.

It does seem clear that in this case a relatively normal bank with a relatively normal set of funding vehicles turned out, on close examination, to be fiendishly complex and opaque; it would be naive to assume that any other financial institution was very different. There is a regulatory lesson here, elucidated in Murphy's comments by jck of the Alea blog:

Regulations like Basel II were supposed to address the problem [of risk capital arbitrage] and the explosion in structured products, SPVs, SIVs and the like shows that the regulators failed...
The regulators should concentrate on the broad issue of liquidity and solvency and not get involved into micro-managing risk for banks…Simply put we need “decomplexification” of regulation and that should lead to “decomplexification” of financial markets.

I'm not convinced that any regulatory action will ever make financial markets less complex, but he's right that it's hopeless to expect regulators to stay on top of the complexity which is endemic to the global financial system. Basel II was a long time in the making, and when it was first mooted it might have made sense to think that regulators could actually understand everything they were regulating. Now, however, they can't, and Basel II is likely to turn into a license for unscrupulous banks to structure their way into difficulties which might have very nasty systemic consequences indeed.