A sombre warning
Mervyn King thinks that the government's efforts to fix the financial system have not gone nearly far enough - and could even be founded on a delusion. That's the not-very-hidden message of his speech to Scottish business organisations in Edinburgh.
It's not just this government that is being too timid. King thinks the entire G20 approach to reforming financial regulation may eventually have to be re-thought. Why? Because it's partly based on the assumption that once you have told banks that they are too important to fail, you can somehow prevent them from taking crazy risks on the taxpayers' dime.
"It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place. The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the 'too important to fail' question."
This cri de coeur does not come out of nowhere. For some time now, policy makers and regulators around the world have recognised that rescuing the financial system had left them with what we economists might call the mother of all moral hazard problems.
In the past, bankers might have suspected that the taxpayers would bail them out if they got into trouble. But thanks to last autumn, they now know for sure.
This is what has been keeping a lot of central bankers awake at night the past few months: if they took all those risks before, when they couldn't be sure they had a safety net, what on Earth are they going to get up to, now that the insurance is there for all to see?
Mervyn King has voiced many of these concerns in the past. But never this bluntly, at least in public. Here's another killer paragraph:
"To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform. It is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector. Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don't, distorts the allocation of resources and management of risk. That is what economists mean by 'moral hazard'. The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The 'too important to fail' problem is too important to ignore."
Logically, there are two solutions to the "too important to fail" problem. One is to accept that such institutions exist, but to impose tough regulations to reduce the chance that they will actually fail. That is broadly the approach being taken by the G20, with a belt, braces and chewing gum approach that will require banks to hold more capital, including more liquid capital, and put caps on total leverage (debt).
The governor says this approach "has attractions but also problems". We never hear about the attractions. But there are two pages of problems, the most important being that you never really know how much capital a bank is going to need - and we've been chronically bad at guessing it in the past. He says that requiring banks to issue "contingent capital" is an important way to beef up this approach. That is debt which turns into equity once certain emergency trigger points are reached. But you still have the basic incentive problem created by the belief inside the banks that they are too important to fail.
We knew that King favoured the more radical alternative - which is to "find a way that institutions can fail without imposing unacceptable costs on the rest of society". In essence, this comes down to separating out the essential, humdrum utility side of banking from the speculative, more casino side that has got us all into so much trouble. We taxpayers only underwrite the bit that's crucial to the broader economy, and by its nature doesn't involve so much risk.
Respectable voices such as the economist John Kay and Paul Volcker, the former Fed Chairman, have put forward suggestions along these lines. But it's fair to say that it has been dismissed as unworkable by the most mainstream opinion, including that of the chancellor.
The Conservatives have rushed to applaud the speech, and to remind everyone who will listen that George Osborne has said he thinks there is a case for separating some of the riskiest investment bank activities from plain old vanilla banking. But he only wants to pursue the idea at an international level. As a unilateral UK policy, the Tories have also dismissed it out of hand.
In his speech King says "it is hard to see why" it would be impossible to distinguish between different types of banking. After all, regulators do so all the time. "What does seem impractical, however, are the current arrangements".
In his blog, Robert Peston has often pointed out how un-radical the post-crisis reform agenda for banking has turned out to be.
For his part, Martin Wolf recently wrote a remarkably radical column in the FT, arguing that the financial sector has emerged rather less secure than the one we had before, and urging greater boldness. "The financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant."
Now Mervyn King has used his bully pulpit as Bank governor to turn up the volume on this debate. I doubt he did so lightly. But quite simply, he thinks that with the current approach, we will only have tackled the symptoms of the problem. The ultimate cause will come back to bite us - perhaps rather sooner than we might have thought.
The governor may not get his way. But in a week when policy makers and ordinary taxpayers are reading in disbelief of a forecast 50% rise in city bonuses, just 12 months after the biggest financial bailout in world history, his speech will add fuel to the fire.
PS: An earlier version of this post mentioned a line which was in the text of the governor's speech, but not in the speech as delivered (an extract of which is now embedded above).