Monday, 26 October 2009

Taking on City excess

Will Hutton pitched into the discussion about whether we should look at fundamental structural change within the banking industry. Last week, I signaled agreement with Mervyn King's suggestion that we should split commercial banking from investment banking. Hutton is clear about the scale of the challenge:
"But reforming big finance ranks alongside climate change and the Middle East conflict as one of the great policy challenges of our time."
However, he doesn't follow King's desire to see banks split down the middle. He accepts Lord Adair Turner's line that such a split would be impractical and undesirable; better instead to manage capital requirements and, perhaps, think about some form of transactions tax if that was insufficient to curb riskier behaviour. Hutton does go much further than Lord Turner in suggesting:
"Britain should now break up its banks that are too big to fail as the US once trust-busted Standard Oil in 1911 when it got far too large – the King solution. The impact on British finance and the powerful financial oligarchs would be irreversible and unforgettable. We could create more than a dozen banks where we now have four – NatWest, Bank of Scotland, and the Halifax should be given their independence again – and new banks created to specialise in infrastructure and innovation financing, where there is a gaping hole. There could be a genuinely competitive banking market, fighting to increase lending in all parts of the country and driving a sustained recovery. No single bank could pose a systemic risk because none would be large enough."
So how does Hutton's trust-busting proposal stack up?

There are three questions for me: does it actually reduce systemic risk, does it eliminate moral hazard, would there be banks that were still be 'too big to fail'?

On the first of these, the proposal fails. The risk inherent in the system (sorry to get all Monty Python on you) is what is risky. Sounds tautological? Well, let me throw another tautology your way. The systemic risk is the system.

Having scattered tautology all around, let me hit you with an oxymoron (stick with this, serious point coming.) John Cassidy sees the financial meltdown in terms of 'rational irrationality.' What he means is that while the medium term consequences of decisions are irrational, short-term decisions are entirely rational. So, for example, a Wall Street CEO who invests in a risky class of financial products knows that he (almost all are 'he') may be jeopardising his firm's future, and knows that if other CEOs are making the same calls then the entire system may be jeopardised. However, he can't but make the investment or his company's stock will forgo growth, his reputation will suffer and he will lose his job.

Over to Cassidy:
"The same logic [rational irrationality] applies to the decisions made by Wall Street C.E.O.s like Citigroup’s Charles Prince and Merrill Lynch’s Stanley O’Neal. They’ve been roundly denounced for leading their companies into the mortgage business, where they suffered heavy losses. In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them. C.E.O.s certainly don’t have much personal incentive to exercise caution. Most of them receive compensation packages loaded with stock options, which reward them for delivering extraordinary growth rather than for maintaining product quality and protecting their firm’s reputation."
Herein lies the problem with the Hutton proposal. The dynamic of 'rational irrationality', far from reducing the risk within the system, could actually increase it. Many banks chasing scarce capital will compete with each other to make ever greater returns. That in itself will increase risk taking. Ah, but aren't these investors wise to risk? No. That's the problem. The whole thing is opaque and riddled asymmetries of information. Goodness, people within firms don't know what is going on let alone investors on the outside.

So the Hutton proposal wouldn't reduce systemic risk and may indeed increase it.

Now, the moral hazard question. While none of these smaller banks would be theoretically too 'big to fail', they would certainly be 'too politically damaging to allow to fail.' Northern Rock was not a big High Street bank but it was inconceivable that it could have been allowed to fail; indeed, it had to be nationalised. This was partly due to the fact that confidence in the system would be shot (remember, the hour by hour monitoring of ATMs.....) but also the political fallout would have been devastating.

So while none of the new 'mini-banks' would be 'too big to fail' as long as their failure didn't undermine trust in the entire system, the reality would be different. What's more, contagion spreads quicker in financial markets than myxomatosis in a rabbit warren. What this would mean in practice is that any executive would still be in a position where they knew they had a taxpayer guarantee. Moral hazard would still apply. Moral hazard and 'too big to fail' are, in reality, two sides of the same coin.

On the basis that I don't see that Hutton proposal- and he has some other ideas for the creation of banks to support infrastructure and innovation which are excellent- reduces systemic risk, eliminates moral hazard, or really solves the 'too big to fail' issue I'm sticking with Mervyn King.

Only by having a commercial banking sector that is very boring, very regulated, and transparent can we shield the UK taxpayer from shouldering the burden of loss while others reap the grotesque rewards. I do not think the system is transparent enough for capital requirements to resolve the issue. The only way is to de-risk commercial banking. I do not think any of Lord Turner's objections are really convincing. There is no reason why the more sophisticated services like hedging could not be offered by regulated commercial banks. They could simply become agents for such services.

Where I absolutely 100% do agree with Will Hutton is that this is one of the big questions of our time. It is one that I fear we are ducking exposing the UK- given the the ratio of the banking sector to our GDP- to perhaps greater risk than any other European economy.

Post script: George Osborne has delivered a speech on these issues today. It contains lots of 'this should happen, that should happen' without much this is how it will happen. Intriguingly, he reiterates his proposal to hand banking regulation to the Bank of England. Yet he doesn't state whether he agrees with Mervyn King's proposal to break up the banks. Well, to support one measure is to support the other so what is it? Vince Cable is explicit in his support.

The rest of the speech is the normal mix of deregulation, rhetoric about red tape (as if the issue facing the British economy was supply side and not demand side!) and his usual stuff about Britain facing a 'debt crisis':
"It is the soaring national debt that sits like a vulture poised to swoop on a sustainable British recovery."
Unfortunately, shoot that bird too early and you shoot down recovery which is what will happen, of course. To his credit, George Osborne is completely honest about his intentions. If we vote for it, then we will only have ourselves to blame.

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