It basically argues on how too much state intervention will creates an incentive for banks to take even larger risk, and how it makes it hard for the banks to expand.COULD there be a better time to be a bank? If you have capital and courage, the markets are packed with opportunities—as they well understand at Goldman Sachs, which is once again filling its boots with risk. Governments are endorsing high leverage and guaranteeing huge parts of the financial system, so you get to keep the profits and palm off the losses on the taxpayer. The threat of nationalisation has receded, reinvigorating the banks’ share prices. Money is cheap, deposits plentiful and borrowers desperate, so new lending promises handsome margins. Back before the crash, banks’ profits just looked big; today they might even be real.
The bonanza is intentional. Governments and regulators want the banks to make profits so that they regain their health faster after roughly $3 trillion of write-downs. It is part of the monstrous bargain that bankers have extracted from the state (see our special report this week). Taxpayers have poured trillions of dollars into institutions that most never knew they were guaranteeing. In return, economies look as if they have been spared a collapse in payment systems and credit flows that would probably have caused a depression.
In an ideal world any government would vow that, next time, it will let the devil take the hindmost. But promises to leave finance to fail tomorrow are undermined by today’s vast rescue. Because the market has seen the state step in when the worst happens, it will again let financiers take on too much risk. Because taxpayers will be subsidising banks’ funding costs, they will also be subsidising the dividends of their shareholders and the bonuses of their staff.
It should be obvious by now that in banking and finance the twin evils of excessive risk and excessive reward can poison capitalism and ravage the economy. Yet the price of saving finance has been to create a system that is more vulnerable and more dangerous than ever before.
The great purge
Some argue that only draconian re-regulation can spare taxpayers from the next crisis. The structure must be changed. Governments should purge banks that are big enough to hold the system to ransom. Or they should seek to slice through the entanglements, cordoning off the dangerous bits. New “narrow” banks would be guaranteed a seat in the lifeboat by the state and heavily regulated for the privilege. The rest of the industry would be free to swim—and to sink.
Yet this search for a big, structural answer runs into two problems. One is that the reform is not as neat as it first appears. Nobody wants to have banks that are so big that they stifle competition (itself a source of stability), but breaking big banks up into tiny bits that pose no systemic risk would be a horribly complex and lengthy task. As for narrow banks, precisely which bit is too important to fail? People’s idea of a systemic risk can change quickly. Today’s rescues have included investment banks and insurers, neither of which used to be regarded as system-threatening.
The second drawback is inefficiency. Limiting banks’ size could stop them from attaining the scale and scope to finance global business. Confronted with restrictions, financiers innovate—in recent years, for instance, risk was shifted to non-banks such as money-market funds, which then needed rescuing. Regulators can stop innovation, some of which has indeed been abused, but Luddites in finance would do as much harm to the economy as Luddites in anything else.
Capital solution
Instead, it is better to focus on two more fiddly things that could produce fairly radical results: regulation and capital. By any measure, regulators need help. That help does not mean creating a new global authority to match the global scope of finance: the money for bail-outs ultimately comes from nation states. But there is plenty of sensible reorganisation to be done—America’s system is a chaotic rivalry of conflicting fiefs, Britain’s an ambiguous “tripartite” regime—and there is a useful general principle to enforce. Regulators should focus on function: if an outfit behaves like a bank, it should be regulated as one, whatever it says on the brass plate. Ideally each jurisdiction will incorporate a set of broad global principles, which establish a benchmark of prudent finance.
Regulators can also use markets. Banks’ solvency depends on a bedrock of capital. Regulators could monitor how this trades, or use markets that gauge the risk of insolvency, to help decide when banks must raise more capital (see article). Regulators could get managers to watch for systemic risks by linking their bonuses to the bank’s bonds. If managers identify with shareholders, as they do now, then they worry only about shareholders’ losses. Catastrophic losses bigger than that are all the same to them. Incentives matter: with higher risk charges on banks’ trading books, bankers would become more discerning about how they put their money to work, and less prone to make dangerous bets in pursuit of huge bonuses.
Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant of and bored by regulation. The more a financial system depends on the wisdom of regulators, the more likely it is to fail catastrophically.
Hence the overwhelming importance of capital. Banks should be forced to fund themselves with a lot more equity and other risk capital—possibly using bonds that automatically convert to equity when trouble strikes. Higher capital requirements would put more of the shareholders’ money at risk and, crucially, enable banks to absorb more losses in bad times. Think of it as a margin for regulatory error.
Regulation cannot prevent financial crises altogether, but it can minimise the devastation. Loading banks with equity slows the creation of credit, but the reward for a healthy financial system is faster growth over the long term. There are three trillion reasons to think that the trade-off is worth it.
Which is weird considering the fact that even with all the money spend, banks has yet to show any major signs of recovery.
