The financial system has stood right at the edge of a precipice on several occasions recently. Regulation has failed to prevent this and so-called free markets and some of their proudest defenders are looking to governments to rescue them. The fiercest debate is now under way about what should be done, and includes calls from the private sector for massive intervention.
One of the leading thinkers in global banking, George Magnus, who is a senior economic adviser to UBS Investment Bank, says: “The consequences of non-intervention in the financial system is to invite such systemic financial failure that you would be inviting a nefarious economic outcome which would be politically, and from a democratic point of view, not acceptable.”
Mr Magnus continues: “The government has to act forcefully and put in place the regulatory environment under which those institutions which receive help from tax payers are going to be properly administered and told how to go about their business.”
The credit crunch and subsequent crises have placed the financial system in terra incognita. The era of steady assumptions is over. The shape of tomorrow’s financial sector is anyone’s guess. What seems established yesterday is up in the air today. The unthinkable in financial markets is today’s norm.
| The unknown is a painful place to be, says Professor Willem Buiter, a former member of the UK’s Monetary Policy Committee. “Fear, panic and loathing are driving markets.” He quotes John Maynard Keynes, an inter-war economist who advocated interventionist government policy, when he says that the market can remain irrational for longer than you can remain solvent. |
The phrase recalls former US Federal Reserve chairman Alan Greenspan’s view that the markets were overtaken by irrational exuberance. How that exuberance has changed to despair and depression.
What is to be done? Responses to this rout are as random as they are desperate, as driven by panic as they are contrived. Opinions range widely.
The Basel capital regime needs to be thrown out and Glass-Steagall restored, says UK economist Tim Congdon, founder of Lombard Street Research. Banking regulation needs complete revision, says Stephen Lewis, chief economist at Monument Securities. Bad banks need to be forced to close or merge by government diktat, says Mr Magnus. The financial system needs to be cut down to size, says Mr Buiter. Middle American banks should be swept away wholesale, say US analysts. This is the time for big ideas and painful thoughts.
Desperate times, desperate measures
Bad times call for grand schemes. Bankers, advisers and economists are scraping around for solutions and explanations.
Mr Congdon lambasts regulation: “The Basel rules have failed utterly. The notion that these rules would sort out the banking system has failed. International regulation has failed. They should close down Basel. The internationalisation is a large part of the trouble. The Basel rules are inflexible. Split up these large banking organisations, stop this nonsense of these conflicted businesses, and there must be local regulators who know the management.”
He believes that the 1933 Glass-Steagall Act, which prevented the combination of investment banking and commercial banking, was “the right thing to do”. Mr Congdon says that allocation of capital between these businesses is very difficult as commercial banks have deposits as liabilities. “They can’t have lots of assets that swing widely in value. Investment banking is potentially that kind of business because they are taking bets all the time.”
Today’s solutions may lay the seeds of tomorrow’s crisis, he says. “The purchase by Barclays of parts of Lehman Brothers is fundamentally wrong. These are businesses that are clearly conflicted. Regulators around the world should stop them from being in one bank holding company. Combining them causes trouble. That is the message of the past 15 years.”
Regulation aversion
| More regulation is the last thing that is required, says Julian Jessop, chief international economist of Capital Economics. He points to Sarbanes-Oxley and the cost and havoc that has caused to the financial community. “This was a well-meaning attempt to deal with Enron. But it was a nightmare of regulation and controls. Increased regulation is an administrative solution that does not work. It is better to get the environment right, in terms of setting interest rates, and you need the right incentives for people to understand the risks they are taking and on the lending side to make sure they aren’t piling up toxic debt.” |
Mr Jessop argues that the parameters for interest rate policy should be widened to include financial stability as well as inflation. “Interest rates have been kept very low to deal with a perceived deflation threat. They weren’t raised quickly enough to control growth in asset prices. This can be blamed on the narrow mandate of central banks, with inflation first and foremost and not thinking about broad issues of financial stability.”
Government intervention
Mr Magnus of UBS has a five-part plan to save the financial industry. It requires government intervention on a scale unthinkable for many bankers and politicians.
State-sponsored recapitalisation is at the core of the Magnus plan. He says: “The most urgent issue is to reconstitute the capital. The state can’t do it for everybody, it has to make political decisions to make capital available for banks. The government has to divide banks into good and bad banks.”
Bad assets should be shunted off, courtesy of the government, into an asset management company like the Resolution Trust Corporation set up in the US to deal with the 1980s savings and loan crisis or the Reconstruction Finance Corporation set up in Japan. Mr Magnus says this “would enable problem banks or assets to be sold or run down in an orderly way, rather than in the cave of a firesale”.
Banks will be pushed together, in the Magnus blueprint, by regulators to create larger consolidated entities, in total distinction to “the small is beautiful” thesis laid out by Mr Congdon. “It is a question of getting stronger brethren taking over weaker competitors. The problems are so widespread, particularly with many institutions relying on wholesale funding which has either been cut back or shut down completely. Some markets have stopped functioning completely.”
Mr Magnus also wants regulators to ease accounting rules for banks harbouring large losses. “No one suggests that the banks should be excused accounting for their losses but there may be legal and regulatory ways so that these losses can be taken in a more orderly fashion. The collapse of the real estate sector also needs attention.”
Government intervention into the direction of the financial system is a last but necessary resort for a system whose internal mechanisms have failed, he says. “For free market people it is not the preferred solution. But I am not convinced that there is any other way forward than to have the government, maybe in cahoots with senior industry leaders, try to sketch out a plan of which banks are worthy of surviving and have sound business practices and which have blown it and should be swallowed up.
“Government intervention is a political as well as as economic and financial issue. In the medium to long run, the greater activism of the state in the financial system will fade over time, much as it did in the decades after the 1930s, and again after the 1980s.”
Moral hazard
The small matter of moral hazard, that is the banks need to take responsibility for their own failures, is a dead letter in today’s crisis, says Mr Magnus. “It is too late for [worrying about] moral hazard. The time to worry about moral hazard is in the good times and to put in place the rules and regulations and structures to make the financial system safer. We are long past that point.
“I am not saying the state should rescue every single financial institution. But there may be some institutions where it is essential to help them survive, particularly if they are not badly run and just caught in awkward funding difficulties. Yet there may be cases where the state has to say we have to intervene.”
Less catastrophic measures are required to restore sanity, says Mr Lewis of Monument. He believes that investment bankers have had their fingers so badly burnt by this imbroglio that they will adopt traditional and conservative paths. However, he believes the authorities need to import a system “which will ensure that in the good years they are required to lay aside reserves to cushion them in the bad years”.
Short-termism clampdown
Remuneration packages must also more accurately reflect risk and success for investment bankers, he says. “The time horizons of bank management are very short, they are always thinking about the next quarter and the implication of those results for their own remuneration. That linkage has to be broken as well. This applies as much to commercial bankers as investment bankers.”
The crisis will trigger further regulation, says Mr Buiter, although he says it is as yet unknown what form it will take. He greets its inevitability with trepidation. “New regulation is required and I dread to think what is being dreamt in the offices of Whitehall and Washington. Many babies will be thrown out with the filthy bathwater.”
There are some certainties for the UK government, says Mr Buiter. One is the decision in Westminster that “none of the major clearers will be allowed to go to the wall. If these banks can no long fund themselves in the markets because of the fear and loathing and panic, the UK government will make finance available. This may involve extending the range of eligible collateral or it may involve buying assets outright from the banks, the way the US Treasury has done from Fannie Mae or Freddie Mac. The government will also encourage shotgun mergers between the weakest of the brothers and sisters. None of these institutions will be allowed to be taken into administration.”
Mr Buiter attacks the Bank of England for excessive caution in placing a deadline on the Special Liquidity Scheme window. The scheme was due to close in October, but it has been extended until January. “That is very nice from the point of view of moral hazard, but it doesn’t address the problem that no mortgage lending is taking place. Potential mortgage lenders can’t fund themselves because the wholesale market has dried up. If the Bank of England doesn’t want to accept new mortgages in this facility, the Treasury should do it itself. The facility doesn’t require the Bank of England. It doesn’t make available Bank of England liquidity, it only makes available Treasury bills and who better to do that than the Treasury.
“The Bank is the agent of the Treasury and it should not have veto power over what it accepts. So you have to widen the range of collateral you accept, price it aggressively, make it expensive if you want the facility to minimise the moral hazard, but nevertheless broaden the range of collateral and the parties eligible to use the facilities.
“They are being overly worried about moral hazard and not appreciating the extent to which they can have their cake and eat it. They believe that if you accept rubbish collateral, you have to accept it and value it as if it were great collateral. But it is still worth something and that is enough to keep the businesses afloat.”
Longer term will come the serious thinking about how governments must rethink financial systems and their regulation. The much vaunted laissez faire system that politicians proclaimed in the late 1970s as the solution to society’s ills has fallen into disrepute. The state will save the banks, but there will be a heavy price to pay.
