The European Central Bank met this week to begin debating a European-wide bank crisis plan. But if we are to avoid further systemic issues in banking, it is the whole structure that needs to be addressed, argues Ian Crowther. We are in danger of learning nothing from the financial crisis, with bankers, policymakers and regulators choosing to tinker around the edges and duck the difficult issues.
The European Central Bank (ECB) begins to supervise Euro-area banks from November 2014, and wants a “strong and independent” resolution authority with a central fund to cover the cost of ‘saving’ lenders.
It would seem this is yet another example of ploughing the incorrect furrow and not dealing with systemic financial risk that pervades the industry.
Instead of attacking the issue from the assumption of failure and costs associated with it, central bankers should also be looking at why systemic failure is present and seeking to minimise the threat of collapse, use of supervision and funding.
Arguments surrounding bank failure, and the socialisation of private sector losses, should centre on structure of the banking industry. We should also examine why senior politicians, central bankers and regulators are not heeding lessons from history, which are as prevalent today as they were in the early part of last century.
As a reaction to conditions surrounding the Great Depression in the 1930s, the United States Government enacted the US Banking Act in 1933, aka Glass-Stegall. This legislation separated retail, commercial and investment transactions within banking.
This not only provided protection of depositors’ money from being used in high-risk ventures by investment institutions but also forbade investment banks from owning insurance companies, or retail banks from conducting securities business; a sensible position to take post crisis, reducing systemic risk.
This compartmentalisation and structure of banking is, I believe, extremely important, and provides a natural firebreak to wide spread contagion and collapse when crisis arises in a globalised and networked banking industry.
However, should circumstances prescribe, such structure would also provide a platform for orderly bank failure, reduced interruption to the financial world, whilst also minimising the need for ECB or central bank planning.
Capitalism requires failure. When agents within the financial system operate high-risk strategies that fail, the investments made by owners of businesses – eg banks – must be allowed to devalue to zero. The central bank should then step in to provide guaranteed liquidity support, with a view to a sales process unfolding and repayment of the central bank from sale proceeds.
Instead, it appears governments and central banks wish to support shareholders in the banks with tax-payers money to prevent ‘too big to fail’ banks from causing systemic failure of the financial world.
This causes the moral hazard argument, so bankers are prepared to take higher risks knowing the lender of last resort is available for bailout and to protect shareholder interests. Shareholders get the upside via 15 to 20 per cent return on equity profits and associated dividends through bull markets, while not shouldering the downside through poor decision making, as shares remain whole through bear markets.
The shareholder holds an ace in his hand throughout this strategy; involvement in the business remains current and share value can increase over time via economic recovery, when by rights ownership of the business should have changed – there is no punitive charge. This is not capitalism but poor policy, which fails to grasp the fundamental issue of structure.
Currently, the process I illustrate above is impossible. The repeal of Glass-Steagall-like policy during the late 1990s led to the current neoclassical view of free markets, maximization of profitability and the financialisation of society.
Currently the banking sector is homogenised where ‘anything goes’ and risk based transactions are not separated into categories of retail, commercial and investment. The Vickers Report in 2011 had ample opportunity to begin dealing with structure of the banking industry but missed the chance in favour of ring-fencing customer deposits.
It appears that governments want to duck the responsibility of protecting citizens from systemic collapse of our financialised, debt ridden world. This is primarily because they fear having to deal with the powerful banking industry and its restructure whilst heading through uncharted waters of deep recession and government controlled money supply.
Inevitably, what we see is an ever more complex world of regulation and supervision (Basel and Dodd-Frank regulation), which we can describe as a compromise to what is actually required and which also fails to address the key issues.
Indeed, in some cases regulation has failed to maintain stability within the banking industry and has created many unforeseen consequences. Pre-2007, it can be argued that Basel regulation caused unbridled innovation within banking, in a search for increased profitability.
Banks began to change business models in a move away from classical intermediation-based businesses lending. Regulation demanded increased capital requirements for lending to commercial businesses, which decreased bank profits and dividends.
In response to regulatory demands, banks innovated and began to lend to one another at zero cost as the risk of banks lending to banks, according to the regulator, involved less risk and thereby increased profits.
This brought about the sub-prime lending debacle, the Collateralized Debt Obligations (CDOs) – pooling debt and selling it as securities to investors – and predatory lending. This failure of regulation and supervision brought the world to its knees in 2007, while the UK’s Gordon Brown and Ben Bernanke (Chairman of the US Federal Reserve) described CDOs as best practice and a concept that reduces risk.
If we are to avoid further systemic issues in banking the concept of structure needs to be addressed. The real fear is that we have solved little since the financial crisis, and the ECB continues to play around at the fringes of what is actually required.
Supervision, regulation and central bank planning, while important, are negotiation positions and therefore compromise which fail to deal with the fundamental issue of banking structure.
What is required is a modernized Glass-Steagall based policy, and for Government to face the difficult questions instead of hiding behind self-interest and challenging problems.