The recent shenanigans over the government deal with the banks (project Merlin) now make more sense, following Anthony Hilton’s revelation in the Evening Standard (reported here in Lib Dem Voice). The deal was weak on the banks because the banks did not get what they really wanted – which was to emasculate the Independent Commission on Banking Reform. George Osborne was quite happy to oblige, it is reported, but the members of the Commission threatened to resign en masse. This means that if the Commission does propose anything radical, an important part of the government will be against it. This will (or should) provoke a major national debate. Time to start marshalling the arguments, and to be all them more ready for the flood of obfuscation and irrelevant arguments that is bound to surround such a debate. Let me offer some thoughts.
Even in a quick and selective overview, I have shot over 1,500 words. I offer this below, but for those without the patience to read through this, my conclusions are these: it is necessary to restrict the activities of wholesale banking so that the returns it makes are substantially lower in ordinary years, and the losses they make in bad years are also much lower; it is also important to make the banks less interconnected. International reforms on bank capital are already doing some good, but we should not be afraid to do more since we are particularly exposed to a future crisis here in Britain. When it comes to the important business of improving finance to support small and medium sized businesses and innovation, we will need new institutions – the big banks will be of little use; the state must promote this type of financial innovation.
One thing is for certain: the established banks will not like any effective reform. If Mr Osborne is taking their side, we can expect a battle royal. It will take both determination and guile to face them down. I will be reflecting on the latter in future posts.
What’s the problem? First, there are two clear and legitimate issues for state policy. We want to avoid the risk of another expensive state bailout of the banking system like that which was forced on us in 2008-2009. Second we want the banks to lend more, at better rates, to small and medium sized businesses with decent prospects, in order to promote job-creation and the improved efficiency of our economy. A third issue is politically toxic, and drawing most of the attention – that a lot of bankers seem to be grossly overpaid, with bonuses drawing particular anger. It is less clear whether this is a legitimate issue for government interference, but we need to understand the issues here nevertheless.
Time to clear the decks a bit so that we can concentrate on what’s really important. Here are some red herrings, to switch metaphors:
- Bank bonuses are often blamed for promoting the crisis, on the basis that they distort incentives and incite reckless behaviour. But why aren’t shareholders, whose stakes are at risk, managing this? In fact the shareholders were as much a part of the problem in the banking crisis as bonus-crazed staff. It is the incentives for shareholders that need real attention; sort this out, and the shareholders will sort the staff out.
- Bankers’ pay is not comparable to that of film stars, sports stars or other entertainers who attract massive rewards. Entertainment stars are a retail phenomenon which, with modern communications, works on a winner-takes-all basis in a mass market. This is different on two counts from banking: the mega-profits are on the wholesale side of the industry; and it isn’t winner takes all either – a huge number of individuals and firms are able to attract oversized pay, not a lucky few in sea of wannabes.
- In fact the issue isn’t really banker’s pay, but why the banks can afford to pay them so much. Investment banking is hugely profitable in the good years. This high level of profitability is a sign of wasteful economics, not a reward for value added to society. A properly functioning industry is not particularly profitable because competition reduces profits. A company at the frontier of technical innovation can deliver big profits and still be economically worthwhile – but this is not what is going on here. There has been a lot of innovation in the banking industry, but not much of it has been to the overall benefit of society.
- For the British, a defining moment of the crisis was the fate of Northern Rock, which had to be bailed out. The reason why a bailout was forced on the state was that retail deposit insurance arrangements were inadequate, which caused a run, and put too many individuals’ savings at risk. This problem has largely been fixed, and what happened to Northern Rock is pretty much irrelevant to the ongoing debate – it is simply a source of obfuscating arguments.
- It is the banks that are the real problem, and not other players like hedge funds and private equity. These institutions may be responsible for some egregious behaviour, but they also address a big weakness in our system of finance: an excessive aversion to risk in most investment institutions. They are not systemically dangerous. To the extent that they are dangerous, it is because of the ease with which they can get finance from the investment banks and over-leverage…which brings the problem back to the banks.
- Finally dodgy lending by banks was at the bottom f the crisis, but it is not the main problem that needs to be fixed. The question is why did so many lenders felt able to suspend the laws of proper management and common sense, and how were they allowed to carry on doing so for so long? The answer is because it was too easy for them to pass buck to somebody else, in the form of securities put together by the investment banks. Securitization was justified at the time as a method of spreading risk – but this proved a fallacy.
Now, the real issues. The first is that wholesale banking (services delivered largely within the finance industry, and not to retail customers – mainly investment banking) is much too profitable for too much of the time. Why? This deserves more analysis, but one problem is clear from the bailouts. Banks are making bets that pay off well most of the time, but deliver occasional disaster. If you add up the bets that pay off with the costs of the disasters, then profitability may not look excessive. But when disaster strikes the downside for bank employees – and shareholders – is limited, and others have to come in to bail them out. In fact many bankers seem to think of the disasters as acts of God that really shouldn’t be their problem. This leads to the risks being systemically underpriced. What to do? The critical thing is to look at how the bets are financed, and to limit the amount that is done through borrowed money rather than the shareholders’ own capital. When things go bad, it the money banks (and various intermediaries they do business through) borrowed from elsewhere and can’t repay that cause the systemic problems, not the loss of their own capital.
The second problem is contagion. If one institution fails then it can bring down others with it, forcing the government to bail the firm out, and creating a wider moral hazard problem referred to as “too big to fail”. The essential problem is that too many financial institutions are lending too much money to each other. Retail bank customers can be dragged into this mix, which tends to force governments’ hands. This is a tough one to tackle, but the key points are to reduce the amount of lending between financial institutions (as in the previous paragraph) and to make sure that banks with retail deposits don’t lend them to other financial institutions, or severely restrict such lending. While trading in securities by investment banks rightly attracts attention, the lending of money to other financial institutions that is used directly or indirectly to buy securities is just as much a problem.
The third problem is the lack of interest by banks (shareholders as much as managers) in lending to smaller businesses. The problem is that to be successful this type of business requires information and relationships, and this requires good quality human input. And that’s expensive. We see big banks polarising into two types of business: wholesale services within the finance industry or mass retail services using computer algorithms and call centres. Not much space in the middle. I don’t think our big UK banks will ever be good at this; it is just too late. We need innovative new institutions. Two avenues are worth investigating: trying to improve venture capital facilities, and setting up publicly sponsored and locally focused institutions to lend to businesses, perhaps drawing inspiration from the German and Swiss systems (see this interesting paper from Civitas).
Basically this boils down to two things: cramping the style and reducing the profitability of investment banking. And encouraging innovation in the supply of finance to small and medium sized businesses. Forcing the current banks to lend more to businesses will not help; they simply won’t understand what is needed. Making the big banks separate investment and retail banking would probably be a helpful reform, but it is not necessary and would not be sufficient. Barclays have managed to insulate their retail from their investment banking businesses quite successfully. Retail banks become exposed by lending money to investment banks or to the shady investment vehicles they create without them being part of the same organisation.
Some progress has been made on restricting investment banks internationally. New international rules on capital are already putting investment banking profits under pressure, although not yet to the extent that they are having to cut pay (see this article in The Economist). Is this enough? Britain is uniquely exposed to financial crises, and we were lucky not to go the way of Ireland and Iceland, with mass bank failures on our hands. We can’t expect much solidarity from our European friends, given how stingy we have been to them. An oil crisis is in the works; property prices could yet fall further; monetary policy and fiscal bailout have run out of road. We shouldn’t shy away from extra measures to reduce our exposure.
Forcing the banks to cut pay is going to be tough going – but it is only then that we will know that reform is working. High pay is rooted into the culture of these organisations. Probably some banks will have to fail first. We must hope that this will be the orderly winding down of some units, but we can’t rule out something worse. And that leads us to a key paradox that will be at the heart of the argument. Measures to make banks behave more safely may well cause some systemic instability. The idea isn’t to abolish financial earthquakes, but to make them smaller and less threatening – even at the price of having more of them.