There are those who dream of returning to a simpler, purer world in which there is genuinely competitive banking, no state
involvement and no moral hazard. But that isn’t going to happen, because the political will would fail at the first major
crisis. We no longer live in the nineteenth century. Sophisticated, modern financial markets have become, in many respects,
a public good, providing not just conventional banking but a system for pensions, house purchases and industrial finance that,
in today’s democracies, will not be allowed to collapse. A better approach is to say that since key firms cannot be allowed
to fail, they must be more effectively regulated.
The rejoinder has been that more regulation will never work. Regulators were too slow to spot the problems involved in syndicated
lending in the 1970s, for example. Cynics argue that if new rules are put in place, financial institutions will find a way
around them. Indeed, the development of SIVs and other vehicles for securitized debt, off balance sheets, was generated in
part by a wish to avoid capital adequacy regulations. Or bankers will simply stop trying to run their businesses in the interests
of shareholders and customers, and concentrate on box-ticking. Or, even if there is a glaring new problem sitting in front
of them, regulators will not see it or act upon it – as occurred with Northern Rock, which was subject to rules written by
supervisors who did not appreciate the significance of the bank having no defence against a breakdown of its business model.
A major government agency was created to oversee the two US housing-finance giants, Fannie Mae and Freddie Mac, but it failed
to spot the problems. I repeat here, in parody form, the weary defeatism of those who say that there is no alternative to
allowing the financial sector to lurch from boom to bust to boom, generating vast profits in the booms and liabilities for
the taxpayer in the busts.
I agree with the analysis of Henry Kaufman, Martin Wolf
and the economically liberal commentators who dismiss this negativism as a counsel of despair and argue that the greater the
commitment to free enterprise the greater the need for regulation, since without it there is excessive instability among the
institutions that are needed to finance the private sector. Smarter members of the financial community are already looking
at how to ensure more effective regulation because they realize that there will be a clumsy regulatory backlash from governments
if they don’t define the reforms themselves. For example, initiatives have been taken in London by hedge funds and private
equity to become more transparent. The three main rating agencies are also anxious to promote voluntary reform, knowing that
they also could become scapegoats in the wake of the unrealistically high ratings they gave to many of the collapsed market
instruments and institutions. They have recently been heavily criticized by the US Securities and Exchange Commission because
of the conflict of interest built into their operations (clients whose insurance is rated also pay the rating agencies their
fees). There is, at first sight, some attraction in self-regulation rather than more expensive and intrusive statutory regulation.
Unfortunately, even if self-regulation is sincere and well-intentioned, it focuses on the behaviour of individual companies,
whereas the problem is one not just of ensuring that firms adopt good practices but of addressing industry-wide, systemic
risk.
There are three areas in particular where a reformed regulatory regime focused on systemic risk would make a difference. The
first, around which substantial consensus has emerged in recent months, is to use the regulatory instruments available to
reverse the pro-cyclical bias of current rules. Banks are required by law to apply international rules agreed in Basle, through
the Bank for International Settlements, which govern the capital they hold in reserve. These rules are applied internationally,
so as to prevent individual countries from trying to secure a competitive advantage for their banks by demanding less reserve
capital than those in other countries. The rules are necessary, but they have
operated, in practice, to reinforce booms and busts. In periods when bank lending is booming, market prices tend to understate
risk, which is why excessively risky lending takes place, yet market prices are also used to assess capital requirements.
Conversely, in an asset market collapse, market prices may exaggerate the loss in value, but they are also used to assess
vulnerability and require banks to cut back their lending when they are already under pressure. If there is a market failure,
the methods used to assess capital requirements compound that failure. Goodhart and Persaud have suggested how a counter-cyclical
policy might work. There is already some practical experience of operating what they call ‘dynamic provisioning’, which is
a counter-cyclical system that has helped to keep Spanish banks insulated from some of the impact of the recent crisis (Santander
has emerged sufficiently strongly to add Alliance & Leicester to its UK portfolio, which already includes Abbey). We should,
however, not be too carried away by the Spanish experience. Spain has had a property boom and bust at least as extreme as
that in the UK. There is also a danger that capital reserves will be used to pursue a variety of different objectives – limiting
bankers’ bonuses and restricting the riskiness of large, complex banks – such that there is simply confusion.
A second theme, along the same lines, is that macroecomic policy, particularly monetary policy, should operate to deal with
asset prices as well as inflation, conventionally measured through the consumer price index (CPI). There is a long-standing
economic argument, going back to Irving Fisher almost a century ago, to the effect that measures of inflation should include
assets. The practical argument is that if interest rates were used to target asset prices, bubbles could then be ‘pricked’
before they became dangerous. The orthodox view, advanced by Alan Greenspan in particular, is that bubbles cannot be satisfactorily
identified, and the role of interest rate policy has to be restricted to cleaning up deflationary damage when a bubble bursts.
There are genuine problems in assessing the degree of over- or undervaluation of
asset markets, but the Swedes have, with some success, used interest rates to ‘lean against the wind’ and damp down the risk
of another bubble wrecking their banking system, as occurred in the early 1990s. Sushil Wadhwani, a former member of the Bank
of England’s Monetary Policy Committee, has set out how such a system could operate more widely.
The measures described above fit within a framework of stronger ‘macroprudential’ policy that the Bank for International Settlements
has been urging in the interests of financial stability. There is another area in which stronger regulation almost certainly
has a role to play: that of remuneration and incentives. There is undoubtedly a good deal of resentment and cynicism generated
by the economic rewards, particularly bonuses, paid in the financial services industry. To the extent that the problem is
one of perceived unfairness, it can be better dealt with through taxation rather than regulation of pay. Proposals from France
and Germany to control bonuses directly run into the obvious objection that extra payments could be incorporated into pay
instead. But within state-owned banks there is a strong argument for trying to stamp out the bonus culture by example. There
is a further argument that the system of remuneration based on bonuses encourages excessive and dangerous risk-taking, which
adds to systemic instability. Since there is unlikely to be voluntary restraint, regulation should insist upon systems that
are already good practice in many companies, with bonuses paid in stock that is not redeemable for some years.
In addition to regulatory reform, there are necessary changes in tax rules to reduce the unintended consequences of policy.
The USA provides mortgage tax relief, which encourages over-borrowing. The UK provides business with interest tax relief,
which encourages excessive leverage. Such practices will have to be reformed.
One of the trickiest but most important areas ripe for reform is the structure of the banking system itself. Nothing has caused
more damage in the UK and the USA than the involvement of what used
to be localized and specialized retail banks in global investment banking. Investment banking has, in recent years, been likened
to a casino, and the massive scale of gambling losses has dragged down traditional business and retail lending activ ities
as banks try to rebuild their balance sheets. The folly – and conflict of interest – in allowing the managers of banks to
acquire equity interest in corporate clients, financed by loans from an in-house commercial bank, was recognized after the
Great Crash and led to the Glass–Steagall legislation of 1933, separating investment and commercial banking. These lessons
were forgotten, and this was one aspect of modern financial liberalization that had dire and almost entirely negative consequences
– as did the de mutualizaton of building societies in the UK. This liberalization now has to be reversed. The sheer scale
of the balance sheets of ‘British’ banks such as Royal Bank of Scotland / NatWest and Barclays – both of which have assets
and liabilities bigger than the whole of the British GDP – is a reminder of how their business decisions impact so powerfully
on the UK economy, and how their errors have inflicted widespread damage, paid for by UK taxpayers. The Governer of the Bank
of England, no less, has called for an updated Glass-Steagall System splitting traditional and ‘Casino’ banking. No one doubts
that the reform is technically difficult. But the proposal is surely right. And until reform is completed there is a strong
case for a levy – in effect an insurance fee – to cover the risk to the taxpayer of banks that are ‘too big to fail’.
There are several kinds of banking structure that could emerge from this crisis. One is that banks, in future, could resemble
utilities, like water companies. They would become essentially national, not international, institutions, servicing business
and individual borrowers in return for ‘lender of last resort’ protection. They would be closely regulated and subject to
statutory codes of conduct, allowed to earn a utility rate of return, and discouraged (or forbidden) from venturing into investment
banking and other high-risk activities. Bank managers would be incentivized to be reliable, predictable and boring, but also
accessible. Financial wizards and thrill-seeking risk-takers would be free to
participate in non-retail institutions such as hedge funds, which, quite explicitly, enjoy no government protection.
An alternative model is that there could be open competition, with bank licences available to a wider range of institutions
– retailers, mutuals, as well as established banks – which would be free to attract deposits, provided that they satisfied
a regulatory test of fitness (that is to say, they are not crooks, tax evaders or straw men). There would be full protection
for depositors, but none for the institutions and their shareholders. Such a model would correspond more closely to a free-market
situation, albeit with depositor protection. A more sceptical view is that, whatever prior assurances were given or refused,
the government of the day would be bound in practice to rescue major, apparently systemically important institutions, as the
Americans have done with AIG, Fannie Mae and Freddie Mac, and the British with Northern Rock and Icesave. All of which suggests
that, in the real world, governments will necessarily intervene, and they should accept this from the outset and move towards
the treatment of banks as regulated utilities.
The immediate priority has been to protect the system from meltdown. But there has to be some link between short-term fixes
and long-term structures. There is a real risk that governments have put taxpayers’ money into the banking system without
having any clear sense of what kind of banking industry should emerge or the political will to impose it on banks that are
well organized to protect their own interests – and their bonus culture.
To introduce reforms of this kind in one country will be difficult enough. But financial markets no longer operate in narrow
national silos. Financial markets are complex and entangled, and do not operate within national frontiers. So any meaningful
regulatory response has to involve cooperation between the main regulatory authorities in the USA, the eurozone, the UK, Japan,
China and perhaps more widely. Otherwise, there would be an open invitation to engage in regulatory arbitrage. We are, moreover,
dealing not with some technical breakers of rules within a
consensual framework, but with something much deeper: a collective collapse of confidence and trust, arising from an orgy
of greed, a feeding frenzy of inflated fees and fantasy profits. It is tempting to enjoy the spectacle of some of the participants
having their reputations, if not their personal fortunes, trashed. But it is neither feasible nor desirable for the system
of modern finance to be destroyed. Information technology cannot be uninvented any more than nuclear technology. The vast,
complex global structure of derivatives that are designed to spread risk still stands. Unlike the Twin Towers in 2001, it
has not collapsed with the impact of the credit crunch, though serious damage has been done. We are still left with a series
of interconnected markets, which were valued by the Bank for International Settlements in 2007 at $516 trillion, thirty-five
times the size of the US economy in GDP terms, ten times the total size of the world economy, five times the size of all the
world’s stock and bond markets, and seven times the size of all the world’s property markets. It has been called a shadow
banking system. The problem remains of how to prevent a rogue 1–2 per cent of the market going wrong, the equivalent of a
Pakistani nuclear weapon going astray. The only practical way in which such controls can be meaningfully introduced is through
internationally agreed rules governing capital requirements and transparency for securitization and structured finance products
and hedge funds, as well as regulated markets to provide a clearing house for complex and potentially dangerous products.
The challenge in terms of cross-border cooperation is immense. The meetings of the G20 have provided a general framework but
the practical work on the ground has hardly begun.