OUR MISGUDED FRIENDS- (NOT ENEMIES )

[james armstrong]

When  the Governor of
the Bank of England , says,

“Of all the many ways of organising banking,  the worst is the one we have to-day.”

We should sit up.

Thanks to Richard Chisnall we can read the full speech on the web.

Thanks to  the
past lectures of two government economists ,Professor Peacock and Cairncross, and
John Mackintosh later to be an M.P . and five years' tuition at Edinburgh Uni-  which our society , not I, paid for,  I am able to pass on to you a précis of
Mervyn King’s 13,000 word lecture in New York in 1300 words.  



We live in a different world now- as a banker said last
week.

 

Speech by Mervyn King 
25th October, 2010 

 

Mr King  refers to
Walter Bagehot  “ a brilliant observer on
contemporary and financial matters” 
and  divides his speech into
four,  an Introduction,  the Practice of banking, 


The Theory of banking 
and he  ends with, Finding a
solution.

 

First. The present banking crisis dwarfs anything
experienced by Bagehot. The worst since 1930’s . At the heart is the expansion
and then the contraction of the banks’ balance sheets.

The lesson is the importance of the resilience of the
banking system.

Not even massive injections 
of both  liquidity and capital by
the state  could prevent a devastating
collapse of confidence  and output
throughout the world.

So we need an answer how to make the system more stable.

 

Second  King describes
the Practice of Banking

Since Bagehot wrote “Lombard Street”
the banking sector first exploded (in size) and then the risks exploded in size
.

The sector  was
broadly stable at  half of GDP  … a ratio - banking to GDP of 1:2  but now (after the growth over the last fifty
years)  to a ratio  of 5 :1.

 

Then the risks associated with banking exploded .and the
banks were allowed to cover them up by putting exposure to the risks off
balance sheet. 

The rate of expansion was accompanied by concentration of
power (which ,surprisingly, King finds ‘surprising’)  -in UK
the asset holdings of the top ten banks amount to  450% of GDP,

And RBS, Barclays and HSBC each individually having assets
in excess of UK GDP 

 

Also assets to liabilities ratio has declined  , before tehcrash “leverage has increased to
astronomical levels “

 Also banks resorted
to using short term (vulnerable) funding .so maturity declined by two thirds.

To cap it all they held a lower proportion of  liquid assets on their balance sheets. So
were more exposed if short tem funding dried` up .

Also  by financial engineering
banks were allowed to  manufacture
additional assets  without limit.

Also they were abetted by ‘vehicles’ in the  so called ‘shadow banking’ system.,

 

The Consequences

 First  the financial system was enormously more
inter-connected which makes it more difficult to regulate since chains of
transaction make it more difficult to locate in one institution. 

Second  gross balance
sheets are not related to the   scale of
the real economy.

So panic sets in.

“The size, concentration and riskiness of banks  have increased in an extraordinary fashion.”  Banks reported profits were exaggerated. ..in
UK…by a
measured 100% . Financial intermediaries add value but not as much  as the statistical convention would suggest. 

The financial sector takes on  risk with the implicit support of the  tax-payer. And makes private profits
from  the implicit subsidy.

 

THE THEORY OF BANKING

Banks are very risky because they  rely too much on borrowing  short term. <Long term equity holders
cannot cut and run so  easily . Banks are
also risky becausae they   are highly
leveraged – they take on  more highly
profitable debt than their  equity
holdings suggest is wise. And when they become illiquid they can be seen as
insolvent. 

This in  turn  means that allowing them to borrow from the
central bank doesn’t solve their 
problem. Banks behave as if they believe in alchemy.  And to work, financial alchemy requires  the implicit support of the tax-payer.

 And ends with
interrupting the  functioning of the
economy – payments, money, and  the
provision of capital, so  Government
cannot sit idly by since institutions are too bi9g to fail. Everyone knows it. 

..highly risky
banking institutions   enjoy implicit
public sector support` . In turn public 
support  incentivises banks to
take on yet more risk 

knowing that if things
go well  they will reap the rewards while
the public sector will foot the bill  if
things go wrong.

There was a descent into hubris. It was an accident waiting
to happen .

.... uncertain value of bank assets… Achilles heel…. Absurd…
dubious claims.

Finding a solution

The guiding principle should be the costs of  crises should fall  on those who enjoy the benefits of
“maturity  transformations”    

a)      impose
a  permanent tax  on maturity transformation* a levy as
discussed at G7.

On the principle that the polluter pays- fixing the price of
the levy will be difficult.

b)      Control
the quantity  of leverage etc,  set capital standards.. ( –a concordat was
achieved in September at Basle.)

c)       Ring fence those activities most
concerned  so  the cost of financial failure would be
reduced. 

Yet Basle lll is not the complete
answer.  It is only a small step and will
not prevent another crisis.

 Because   accepted capital rations fail to   predict 
which institutions would be vulnerable 
. also ‘past experience’ failed to predict  what happened in 2008. Northern Rock  ran out of money within weeks of announcing
it intended to return capital to its shareholders.  Basle 11 was based on
a judgment that mortgages were the safest form of lending. irrespective of how
they were financed a model which then became unviable.

Banks should use profits to rebuild capital rather than pay
highertr dividends and compensation . Fixing 
a permanent tax on maturity transformations is vital.  

Because it tries to induce stability by  building assets when the difficulty is
assessing risk.

Because Basle ll looks at banks’
balance sheets when the risks are off balance sheet.

And ignores banks’ vulnerability to illiquidity  which can induce failure.

The B of E will not ask banks to build up assets faster, it
is a long term  task.

“We need radical
reforms”    

 

On LARGE INSTITUTIONS

“Solving the ‘too important to fail’ problem will require
ultimately that every financial sector entity can be left to fail without risk
of threatening  the functioning of the
economy.  In many countries big steps
forward have been taken.

There needs to be 
restrictions on the maturity structure of its liabilities.

    

MORE RADICAL REFORMS

One simple solution advocated by David Miles  would be much higher levels of capital  require by several orders of magnitude.   Leading to the proposal to introduce
‘limited purpose banking’ (Kotlikoff)  This cuts out alchemy. It needs studying.  Functional separation is another
proposal  divorcing payments from risky
lending activity.  That is to prevent
fractional r3eserve banking  (see Tobin
etc)

In essence these
proposals  recognize that if banks undertake
risky activities it is highly dangerous to allow  such gambling to take place    on the same balance sheet  as is used to support the payments
system  and other vital parts of the financial
infrastructure.  Genuinely safe deposits
should not co-exist with  risky assets. 

A key challenge is to ensure the   maturity transformation does not migrate
outside the   regulated perimeter.  , an end upp benefiting from the implicit
public subsidy.- which is the nature of these services.  And so difficult. 

Suppliers of funds
muist understand they willl not be protected. 
Fromloss by the tax-payer. Creditors must know they may bear losses.

 

FINAL PARAGRAPHS 

The broad answer is
likely to be  remarkably simple.  Banks should be financed much more heavily by
equity  rather than by short term debt.
Much much more equity.  Risky investments
cannot be financed in any other way.

 

“Of all the many ways  of organising banking,  the worst is the one we have to-day.”

There is no simple answer to the  “too important to fail” nature of banks. 

“I have explained the principles on which  a successful reform of the system should
rest.  It will take many years.  To quote Bagehot “

“I have written in vain, if I require to say now that the
problem is delicate, the  solution is
varying and difficult,  and that the
result is inestimable  to us all.” 

COMMENT

The banks with their ‘hubris ’ are already opposing King, have
continued payment

Of  bonuses  to traders (some of them in cash now some in
shares).  The Government has recently
announced the intention of reducing the regulatory regime, not increasing it as
King suggests.  So  how is control of  these corporation to be exerted?

Just three banks, as King reports, each have  a greater capitisation than the UK Gross
Domestic Product.

My proposal is  to cut
corporations down to person size. By imposing a variable but renewable
termination date  to each
corporation  which as we so often
overlook, has been granted corporate existence by society . The threat of
bringing forward their termination date will encourage compliance.

James 

 

 

 		 	   		  
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