OUR MISGUDED FRIENDS- (NOT ENEMIES )
james36armstrong at hotmail.com
Sun Dec 5 16:23:42 GMT 2010
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
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
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
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
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.,
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
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
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.
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…
Finding a solution
The guiding principle should be the costs of crises should fall on those who enjoy the benefits of
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.
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
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
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
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
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.
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.”
The banks with their ‘hubris ’ are already opposing King, have
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
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.
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