Demonstrators protest outside the Goldman Sachs building in New York, - a national protest against major U.S. banks calling on Congress to take action on banking reform.Are governments really getting to grips with financial reform? Or, are they being stymied or diverted by myopic bankers? One of the successes of responses by states to the credit crunch crisis has been the almost measure for measure coordination of responses between the USA and the UK. When it comes to weight in world banking and finance the UK alongside USA at the top of the totem pole wholly disproportionate to the relative size of their underlying economies. Last Thursday, Obama called for the biggest regulatory crackdown on banks since the 1930s (when Glass-Steagal separated traditional banking from investment banking), proposing strict limits on the size of financial institutions (none to have more than 10% of the US market) and a ban on proprietary trading (speculation by the banks for their own profit and not on behalf of customers) and therefore also no banks to have internal hedge funds. If enacted by Congress, Mr. Obama’s proposals could force Wall Street names like JPMorgan Chase and Goldman Sachs to spin off their huge hedge fund and private equity operations and stop making trading bets with their own money, or de-register as deposit-taking banks. In the UK Adair Turner, head of the FSA (regulator) and others have coat-trailed similar ideas. New, unspecified controls on liability risk ar also envisaged – this would catch up with the UK where tough new rules are enacted and will be followed shortly by the EU. Banks will have to prove their liability management systems and hold reserves of high quality that may add 30% to banks’ capital reserves. The liability risk rules extend to non-banks. Commercial and investment banks are to be prevented from growing so large as to anytime again pose a systemic risk.
This last intention is a deeply flawed hope. The network risks of a bank causing a systemic crisis such as Lehman Brothers or WaMu, or HBoS in the UK, may be triggered at far lower than 10% market share. Moreover, the problems of one bank if not caused by a technical operational failure but due to changes in the economic environment are bound to be common to all banks. Banks that were seen to survive with less need of Government support did not do so because they were inviolate to the problems – it was relative, and the equity investors and short-sellers only had so much appetite to dump the banks – it was a matter not of all skittles being liable to fall but merely which fell first. Any of the big banks could have been first – there was a certain amount of luck and bad timing so that, if we think of the credit crunch as a fire fight some banks took the bullets aimed at all of them. Those first in line to be shot were those who had to go to market to refresh their funding gap finance before the others in the worst months of 2008.
G20, UK and USA reform proposals represent an intelligent shift to look at the liabilities side of banks’ balance sheets, previously ignored in Basel II regulation. The popularly phrased idea however of building up reserves in good years to cushion the lean years is flawed. The credit crunch + recession is wiping out banks’ capital by 200% gross (before recoveries and continuing internal capital generation). Therefore even if banks had double the reserves they had in 2006 they would still be in crisis!
At this stage, the primary focus is on banks, but double-default risk (part of Basel II Pillar II) remains an issue in respect of the capacity and role of insurers in underwriting banks’ risks. Insurers are competent to cope with single failures, but not when a whole banking sector faces capital wipe-out, and a 90% wipe-out is normal in for a normal recession (one not preceded by highly borrowed banks failing to turn over their medium term debts as these became due).
In Europe there is a broadly based approach where Solvency II for insurers is almost identical to basel II for banks. The USA must attempt this also - a wide-front approach that applies to non-banks and insurers in much the same way as applying to banks. In fact this is now implicit in the global IFRS accounting standard,
Restoring the New Deal era Glass-Steagall Act’s complete separation of investment and commercial banking activities is argued by banks and their supportive economists in Wall Street firms as not the right direction to go in because it does not solve the “too big to fail or cause systemic crisis” problem. Whether separation is necessary or desirable, the argument does not hold water. The essence of Glass Steagal was to make commercial banks solely dependent on the economy and not put large amounts of their capital (retained earnings) at risk supporting investment speculation fuelled by banks’ borrowing their bets from others. Banks necessarily have to hold deposits with each other. They have to provide liquidity to markets either directly or by lending as they do to prime brokers and other markets traders. Glass Steagal merely ensured that banks’ speculation in markets for themselves was at one remove. The collateral they hold from borrowers also means they have many ways of participating in customers’ businesses.
What could be limited is the practice of wrapping up loanbooks and securitizing them for sale as bonds. This enabled the banks to push the growth of their loanbooks faster than the rate at which they attract deposits. When government borrowing is low and therefore private savings rates are also low (they are exact counterparts in ratio to GDP) then banks are forced into relatively low growth as they see it. In effect therefore, the restrictions being proposed are for big banks to only grow at the rate of the economy plus inflation. Big German and Japanese banks have traditionally used bonds indirectly (not directly) backed by loanbooks, and big US banks too that did not have extensive retails networks. There are other options; structured finance is extremely flexible and creative. Therefore this is not a genie that can be pushed back into Aladdin’s lamp. More vital is to try and ensure that banks’ lending profiles are less driven by where they feel they can get biggest profit returns and more by risk diversifying across the whole economy. When mortgage lending is 20 times greater than lending to small firms something is wrong!
Some bank economists argue for lower capital requirements coupled with greater restrictions on securitization, for which read wholesale borrowing, as opposed to higher capital requirements and liquidity risk controls - the direction of new regulations. They object to the new regulatory attention to the
liability side (deposits and borrowing) of the balance sheet. But it is this side where the credit crunch happened! They want regulation to do what it was doing before – only focusing on the asset side of the balance sheet (credit risk of loans and market risk of investments ). Governments made the banks pay insurance premia to them to insure all deposits. This was a classic confidence restorative. But, it was the loss of confidence by lenders to banks that caused the credit crunch, and not the credit risk defaults by mortgage and other borrowers – those could be coped with. What could not be coped with was sudden technical insolvency when banks could not get their liabilities to balance their assets.
What made big banks not too big to fail was not their balance sheet size; it was the size of the funding gaps that had burgeoned between deposits and loans, so that a third or more of liabilities could b short to medium term borrowings. Capital was then wiped out too, not by credit risk losses but by market risk writedowns and massive equity falls in the stock markets.
With that in mind, many activities of the banks need to be capped, banned, taxed and/or substantially re-regulated.
One idea canvassed in the USA is for government to continue to guarantee all banks’ depositors and bondholders, not just to the present $250,000 deposit ceiling but totally. With banks funded without limit by government-insured deposits and loans from the central bank, discipline should entirely focus on the asset side. This may work, but it does mean that bondholders should not expect yields above those on government paper. This may by itself limit the ability of banks to over-borrow. If not, then caps are required on how much banks can borrow as a % of their assets. Such discipline must include limiting banks to assets deemed ‘legal’ by the regulators and restrictions on off-balance sheet activities (mainly derivatives including credit derivatives. That will limit leverage-financing to non-banks who have relied on credit derivatives to emulate the liquidity of interbank money markets. Money markets would themselves deflate in size as interest rate futures and other plays become less justifiable.
There is a mistaken argument about enforcing higher capital ratios that is commonly subscribed to by banks. That is that capital ratios going higher act functionally like a tax to restrict the banks’ ability to lend, and thereby raise the returns demanded from the borrower. This is simplistic. What really happens is that banks have to retain more earnings and in the first instance withdraw a lot of own-capital presently committed to proprietary trading and apply that to capital reserves and vest these in money market funds or directly in government stocks.
Given that banks have capital committed to proprietary trading that could be recovered for capital reserves, then higher capital ratios (built up over a reasonable period) should not restrict traditional lending even if it does raise the common cost of funds for banks, which can effectively be passed onto household and business borrowers i.e. onto consumers, i.e. marginally higher borrowing rates or narrower net interest income to the banks. The result will also be lower dividends for bank share investors. In the decade before the credit crunch bank profits and shareholder gains were double the average for stock markets. There is therefore some grounds for actions to restrict this. A related question is how higher capital ratios can also be gamed via risk accounting scams – but that’s for the regulators to sort through in fine detail.
Banks are set up and supported by government for the benefit of the economy. Consequently, banks should be prohibited from engaging in secondary market trading – this is a compelling view, why, because it serves no public purpose and may result in severe social costs in the case of regulatory and supervisory lapses. Banks should only be allowed to lend directly to borrowers and then service and keep those loans on their own balance sheets – the idea of a return to traditional banking.
But another key objective is to ensure via financial reform that markets remain liquid and deep. This means relying on a large number of smaller institutions carrying on traditional banking activities including trading in the markets, rather than having these activities concentrated in the hands of a small number of dominant highly capitalized global institutions. Truth is that generally in the major markets no players have over 5% when looking at all data properly single-counted. But that is enough to move the markets. We need to renew our studies of the quality of markets and bring over-the-counter trading back onto regulated exchanges – ideally banning algorithmic automated trading, many of the games that go on, and ending much of the anonymity of automated central order books and balance this with direct contact between buyers and sellers but via the exchanges. In regard to proprietary trading, hedge funds, private equity operations, and other pools of unregulated funds should be allowed to continue to operate. But they should be allowed to fail when their bets go bad. What is needed is a protected and closely regulated large core of the financial markets for those who do not want excessive risks.
In the USA, the top 4 banks (BofA, Citi, JPMorgan-Chase, and Wells Fargo) hold half of the country’s deposit base. In the UK, 5 banks (HSBC, LBG, Barclays, RBS, Santander) hold 75%. But these %’ages do not translate into wholesale markets which are not national but global! Banks seeking to grow beyond their borders have veered back and forth between doing so by buying retail networks or more investment banking capacity, sometimes both. The major consequence of thirty years of financial deregulation is that it has rewarded destructive competition in domestic banking rather than constructive competition, with big banks getting bigger, and domestic banking more concentrated, so as to finance big banks’ ability to seek bigger shares of global markets, where they all have a long way to go. Arguably, an acerbic view, is that regulation has so far rewarded banks who grew their market shares by any means without any consideration for others (especially the financial well-being of borrowers or the general economy), and it punishes financiers who refused to resort to unprofessional underwriting practices even if it meant a drastic reduction of their market share. The time has come to construct regulation which rewards the latter (usually smaller banks practicing traditional ethics) and punish the former.
