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It is not surprising that greater internationalisation has encouraged demands for closer co-operation between regulators in different countries and in different industries. It is an irony that a country with one of the most sophisticated financial systems, the United States, also has one of the most fragmented systems of regulation. While other countries moved during the late 1990s to reduce the number of regulatory bodies – the UK, for example, has a single omnipotent Financial Services Authority – the United States has been reluctant to tamper with the jurisdictions held by such bodies as the Federal Reserve, the Securities and Exchange Commission (sec) and the Commodity Futures Trading Commission. As a result, duplication among agencies abounds.

Nevertheless, there is little doubt that regulators, particularly those that preside over the world’s most sophisticated financial centres, are now co-operating much more than they used to even a decade ago. Although no single regulator oversees the giants of international finance (nor perhaps is one ever likely to), such firms are watched closely wherever they trade in the developed world. The key to effective regulation and smoothrunning financial markets is transparency as well as the free flow of information.

One hope is that the improved regulation of banks will provide early warning of dangers. Under the Basel rules of the 1980s, banks have had to link the amount of capital they must hold to the level of risk carried by the loans they make. This sounds fine in principle but does not always work in practice. Critics claim that the system is too crude: banks have to set aside as much capital for a loan to General Electric as they do to a hotelier in Poland. Basel 2, a more sophisticated version of the rules, is being drawn up by the central banks of the developed world. It would cover many more banks worldwide. Yet central bankers have found it difficult to agree on the scope of the new rules and how they should be applied. For example, some want more leeway for banks lending mainly to small businesses because, in theory, the risks are fewer. Originally planned for 2004, the introduction of Basel 2, as the new rules are known, has been delayed until 2006, and even that may be in doubt.

Better regulation of banks may reduce the chances of a collapse in the financial system, but should regulators also be thinking about ways of preventing the investment bubbles that lead to capital being misallocated in the first place? Until the dotcom bubble burst, the answer was invariably no. Advocates of efficient market theory argued that the system was inherently self-correcting. In efficient markets, prices are assumed to reflect fundamental values and to price in all available information. If ill-informed investors move prices away from their true value, informed ones will simply arbitrage them back again.

Purists believe that if share prices rise to a level for which there is no obvious explanation, then investors will conclude that there is another less obvious explanation, such as the dawn of a new age of productivity or, as dotcom enthusiasts believed at the time, a “new economic paradigm”. What believers will not conclude, at least until after it has burst, is that a bubble exists – which, of course, is both irrational and inefficient.

Many observers would like to see the Federal Reserve and other central banks attempt to control not just the level of inflation, their main preoccupation, but asset prices too. They argue that the costs of pricking an inflating bubble – possibly recession, deflation or sometimes a combination of the two – outweigh the risks of raising interest rates pre-emptively to prevent a bubble forming. After all, argue interventionists, history is littered with examples of the results of inaction on the part of central banks that have resulted in problems of a comparable magnitude; for example, Japan’s prolonged period of economic stagnation and occasional deflation following the bursting of its own asset-price bubble in the early 1990s.

The danger, of course, is that when a bubble does burst, its impact can be far-reaching, not just on the financial markets but also on the underlying economy. The wealth effect, which helps to boost consumers’ confidence and so propel share prices ever higher when markets are rising, also works in reverse. Equally damaging can be the sudden loss of confidence produced by a realisation on the part of investors, particularly private ones, that they have been duped.

Revelations in 2002 by Eliot Spitzer, the crusading attorneygeneral of New York State, that investment banks on Wall Street had routinely touted shares in public which they privately believed to have been “junk” had a predictable result. Aggrieved that they had been misled when they bought the shares of companies seeking initial public offerings during the heady days of the technology boom, investors called their lawyers and sued. It was not so much the knowledge that investment banks suffered from conflicts of interest – Wall Street has long had to balance its own interests with those of its clients – but the blatant way in which the abuses had occurred.

The revelations cast doubt not just on the legitimacy of Chinese walls, the ability of investment banks to separate one function from another and therefore the interests of different clients, but also on the role of the securities analyst, the individual whose job it is to analyse the businesses of individual companies and to put a value on their shares. For years investors had taken what analysts write with a pinch of salt because, after all, they are often part of investment-banking teams that advise companies on (lucrative) acquisitions, mergers and the like. But the degree to which investment research had become the handmaiden of investment banking shocked many of them. Investors were also surprised by the extent to which the directors of big companies had been handed perks (often by giving them priority in share issues that they could later sell at a hefty profit) in return for investment-banking mandates and other advisory work.

Litigation between the banks, investors and bodies such as the National Association of Securities Dealers, the regulator of nasdaq, is likely to rumble on for years. However, the combined fine of nearly $1 billion that Spitzer levied on a group of Wall Street’s largest investment banks, together with $500m or so to sponsor independent research and to educate investors, should encourage higher standards of integrity and professionalism among investment bankers.

Some investment banks have taken the precaution of casting off their research staff into separate companies with their own management. But research on its own rarely pays, at least not well enough to cover the multimillion-dollar bonuses that star analysts came to expect during the boom years. Many observers believe that what is needed is a change of culture, not just a change in the rules. This will be hard to bring about. There are dangers, too, in trying to reverse the deregulation that has occurred, particularly the separation again of trading in equities, bonds and derivatives from the advisory work that, during good years, accounts for the lion’s share of investment banks’ profits.

That could change the nature of financial markets and, possibly, make them less liquid. Trading volumes could decline and, perversely, the banks’ customers could also suffer because companies and investment firms might find it more expensive to hedge their risks and to react quickly enough to changes in the markets