Holy smoke
They halved pensions instead. Photo: Cate Gillon/Getty Images
“If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure.” Mervyn King, June 2009
Imagine you run a corporation called the Church of England. You earn your daily bread by accepting small donations in exchange for sermons. One day, you decide that you want less Hovis and more Wagyu. You achieve this not by increasing the number of donations but by securitising income flows – the pennies that people put into the collection basket on a Sunday morning – and investing the newly raised capital.
Then the invisible hand of the almighty lets you down. Your congregation dwindles and revenue streams decrease. Because of the economic climate, the FTSE 100 plummets, dragging down the value of your investments. You lose out to the tune of 1.2 billion pounds and have to confess to young vicars that you’ve denied them more than half of the pension rights that recent retirees enjoy.
The moral of this story is simple. “If you want markets to function,” as Boston University economists Christophe Chamley and Laurence J. Kotlikoff argue, “don’t let critical market makers gamble with their businesses.” Economists, no longer red in tooth and claw, are now adding to the church’s pile of grievances by eating into its ideological territory, preaching morals rather than greed.
Apply Chamley and Kotlikoff’s moral to banks and “the regulatory prescription is clear.” Banks that take risky decisions in the financial markets stray from their core social function of “mediating the payments system and connecting lenders to borrowers.” Safeguarding the payments system would mean obliging the banks to hold reserves against their deposits in a ratio of 1:1, a system known as 100 per cent reserve banking.
Under a 100 per cent reserve system, banking as we know it today would be a crime because leverage would be illegal. Bank runs would be history and wholesale lenders would operate with confidence because banks would carry zero risk on their balance sheets. Financial intermediation would be limited to mutual funds, the owners of which would bear all risks. With what has come to be known as “limited purpose banking”, the prophets say, there would be no financial crises or bank failures, credit would never dry up and the public would never be exposed to privately incurred liabilities.
Next to such radicalism, Mervyn King’s proposal for a 21st century Glass-Steagall act to separate “high street retail banking” from “risky investment banking” appears benign. The UK government has expressed irritation at Mr King’s suggestion, arguing that the idea of narrow banks is an anachronism and that the solution lies in what it calls “living wills” – an idea that Mr King himself does not discard, instead calling it an “important practical step” and proposing to combine it with higher capital requirements.
Martin Wolf, writing in the FT, rejects the idea, arguing that the arrangement would still require the government to remain the lender of last resort, implicitly underwriting dangerous liabilities and explicitly guaranteeing deposits. Mr Wolf argues that even the idea of narrow banks, as proposed by John Kay, does not protect the public against risks posed by financial intermediaries operating in the shadows of this new banking system. Instead, Mr Wolf asks, why not force investors to bear all risk by keeping the value of financial intermediaries’ liabilities at a level not exceeding the value of their assets? More pointedly, do we really want to end leverage?
Mervyn King might be willing to fight for a deal, but EU competition commissioner Neelie Kroes has other ideas. Her heavily pragmatic response to the financial crisis is quickly pushing the fashion for radical, no-compromise debates off newspaper pages and back into the margins of academia.
Writing on 28 October, John Gapper argued the case for separating “utilities, casinos, and people who visit casinos to gamble.” The difference, Mr Gapper points out, is subtle yet important. Many of the institutions that Mr King calls “too big too fail” are made up of retail banks that deal with high street customers, investment banks and asset managers, including private equity and hedge funds, and which serve a completely different class of client. All these interests pitted against each other under the same roof make for less serenity than a Big Brother household.
Under the system that Mr Gapper proposes, retail banks would operate like the clearing banks of old, and would be “tightly regulated” but would still benefit from the implicit guarantee of a government bailout. Investment banks would have to fund themselves privately and would not accept retail deposits. Their asset management arms would have to be spun off, a move that would cause opprobrium but which would allow high risk-takers to play their own game without ruining it for everyone else.
That last point is important. It means that although leverage would be more difficult, the effect of a risk gone wrong would be mitigated and firms could be left to the ravages of the market. Coupled with the imposition of wills, theoretically any firm could be allowed to fail safely.
Still, as realistic as this compromise sounds, the likelihood of it being made a reality seems small, at least for now. The governments of France and Germany are certain to resist any changes to the structure of their universal banking systems. They would rather play to the gallery with vague and ill-conceived pay regulations that, we now know, were never at the heart of the financial crisis. After all, who could argue convincingly that the Church of England’s reckless gamble was the result of bonus-driven incentives?
There is a yawning gap between thinking up the ideal solution and actually getting the disunited states of Europe to implement it. As with the deathbed conversions of sinners, progress in Europe is generally the result of a crisis but continental Europeans have yet to experience any crisis of conscience for saddling an entire generation with debt or, indeed, a crisis of any kind.
The global financial crisis is largely perceived to be rooted in the UK and the US and there has not yet been a return of the kind of continent-wide instability that eventually produced the European Union. It seems that nothing short of divine intervention could break the current impasse. Perhaps, for a fee, the Church of England could act as intermediary. That would solve their crisis and the world’s at the same time.
