Banking Reform
The debate upon banking reform in the UK has so far been woefully inadequate. The various commentators have been discussing narrow aspects of the issue, when what is required is a holistic plan. The long term outcome of reform needs to present a balance between two imperatives: on the one hand global economic and social development can benefit enormously from constructive credit provision, and this should not be thrown away; on the other hand the cost of a failed credit system is too great for us to allow it to be repeated.
The debate has various component parts: regulation; capitalisation; the range of activities allowed; and the roles of shareholders and non-executives. All these components inter-relate, and thus cannot be seen rationally in isolation. A globally harmonized approach would be appropriate, and greater future transparency should be obligatory.
Regulation and capitalisation are both essential parts of the debate on whether banks are fit for purpose. But which purpose? Should a new version of the Glass Steagall Act become law? Arguably consumer oriented banking is an essential public utility. If this is the case, as credit crisis responses suggest, then parts of banking activities which relate to creating excess returns by using sophisticated mechanisms should be separated from them. They would then be regulated and capitalised in quite separate ways. If the size and number of players was then reviewed in this new context, then their conclusions for the two types of banking might be quite different. The perception of being too big to fail would be different for a utility than for a risk-oriented enterprise.
It is socially, morally and financially unacceptable for risk-oriented bankers to dominate the argument over the outcome. While one can understand why they argue that access to cheap “consumer” capital enhances their competitive position, it is precisely the misuse of this capital and the mispricing of the cost of this capital that got them into the current mess. They are simply too big to keep saving. It can be argued that the Lehman Brothers failure shows that it was not size or the combination of retail and investment banking, which caused the crisis, but the interconnectivity of banks. But this is specious and only true in part. Lehman’s collapse was the catalyst only because the overall situation was already dire. That said the interconnected nature of banks must be unplugged.
The solution should entail more transparency over the system, utility and financial structure of banking. Utilities require a stronger capital base than riskier banks, so both should exist separately within distinguishable remits. Suitable regulation could thus be set for these different activities, and their appropriate sizes and market shares can then be debated productively. Regulation would include capitalisation, and perhaps ratios which adjust through the different points of the cycle. Greater transparency is essential. Banks should disclose everything to which they have financial exposure, and this should include all those items which have been hidden off balance sheet. The management of risks of a failure to the flow of capital should also be improved. OTC trading should be brought substantially onto exchanges, and clearing systems should be used for all transactions.
Future tests would then be done on the basis of whether the costs of a failure of the system could be contained within the two banking sectors, and these tests would be performed with complete information. Nothing else would be fit for purpose.
It is easy to say that shareholders and non-executive directors should have been more proactive. But in practice such intervention is difficult to implement. Law and practice both legislate against corporate management telling outsiders fine details of their activities – just compare published and management accounts to recognise this, or consider just how a person who spends one day a month attending the board meetings of a complex business could possibly begin to perceive the details of some of the bank’s products, especially if they are off the balance sheet. Greater transparency would aid their efforts to do a better job.
An interesting suggestion is that short sellers should be engaged actively by non-executive directors. It can be shown quite clearly that short sellers did not create the banking crisis, however a significant number of talented hedge fund managers had shorted bank stocks: with the benefit of hindsight one can see how useful it would have been if non-executives had been well briefed by hedge fund managers. This shows that short selling should not be banned.
Taxpayers should never again have to bail out failed banks. This demands that banks are left in the private sector, and that the impact of their demise would be contained therein.
August 2009