Mervyn King says banking must be reinvented
I am away from the mothership for a few days, but I could not resist beaming back a few thoughts about the remarkable speech given last night in New York by Mervyn King, Banking: from Bagehot to Basel, and back again [147.81KB PDF].
The governor of the Bank of England - which, let us not forget, is being endowed by the coalition government with direct, formal responsibility for making sure banks don't go bust (prudential regulation) - said:
"Of all the many ways of organising banking, the worst is the one we have today."
To coin a cliche, "tell us what you really think, Mervyn".
His analysis is one that will be immensely familiar to readers of this blog, namely that there is always a risk of financial and economic crises when banks turn short-term borrowings into long-term loans - because what he calls the "alchemy" of fractional reserve banking is only sustainable for as long as the lenders to banks believe that their money is safe, and that cannot be guaranteed at all times.
So the challenge for governments and regulators is to ensure that the costs of averting or curing these inevitable banking crises don't fall to a massive and unfair extent on taxpayers and society as a whole, rather than on the private beneficiaries of maturity transformation, the winners from the magical process of turning demand deposits into risky loans to households and businesses.
Or as Mr King puts it:
"What we cannot countenance is a continuation of the system in which bank executives trade and take risks on their own account, and yet those who finance them are protected from loss by the implicit taxpayer guarantees."
Here's his big point: when society cannot afford that lenders to banks should incur losses, whether those losses are for retail depositors or wholesale institutions, then bank executives will have a licence to take "heads they win, tails we lose" risks - which is unfair and unsustainable, as the 2008 banking crisis demonstrated.
What's to be done?
For Mr King, the recent Basel III accord - on boosting how much capital banks have to hold as protection against potential losses, on better aligning the maturity of liabilities and assets, and on how much liquid resource banks must retain to ward off the lethal impact of runs - is only a start.
To put it another way, it is a minimum set of standards that was necessary to obtain international agreement. But it's not good enough.
What might be good enough?
Well, Mr King says we need to look at highly radical reforms of the banking industry - each of which will probably strike terror into the hearts of those who run our biggest banks.
First, there are two complimentary proposals:
1) That retail banking deposits must never be used to finance risky loans, that the all-important payment system should be divorced from providing finance to businesses and even to households. These ideas have at various times been advocated by the economists Milton Friedman, James Tobin and John Kay - and have a champion in Parliament in the form of the Tory MP Douglas Carswell.
2) That loans to businesses and households should always be repackaged into pooled investments held by mutual funds, so that - in effect - there are no longer short-term liabilities funding long-term assets, there is no longer a mismatch between a demand deposit and a longer-term loan, there are simply investors prepared to take some risk in financing the economy. This model is associated with Professor Kotlikoff.
If banking were reconstructed along these lines, there would in theory no longer be any need for taxpayer guarantees for banks - because bank depositors would not be takings risk or placing bets on the solvency of corporate and household borrowers.
What would look like a more conventional reform look like for Mr King? Well, it would involve a massive increase in the amount of loss-absorbing capital that big banks have to hold, well above the new Basel III minimum of 7% of risk-weighted assets.
According to regulators, something like 30% of a big bank's liabilities would have to be equity or convertible into loss-absorbing equity, to stand a good chance of insulating taxpayers from the costs of bailing out a bank in a crisis (for those who care about these things, that 30% would consist of common equity, contingent convertible capital or CoCos and bail-in debt that turns into equity when regulators ordain that it must).
So although this may sound like a more conservative solution, it would be viewed with horror by most bankers - who would see it (wrongly, according to the likes of Mr King) as massively increasing their costs of doing business.
But Mr King has a final argument for the bankers who will inevitably argue that if the UK carries out all or any of these reforms in a unilateral way the costs to the vibrancy of the City of London and to the UK economy would be prohibitive.
He argues that there has been a massive overstatement of the wealth created by the UK's banks for two reasons.
First, he says the national accounting conventions wrongly attribute to banks all the benefits of providing finance, rather than sharing those gains with the recipients of that finance.
Second, and more importantly, the explosive growth in apparent "value" added or created by banks in the years before the 2008 bust stemmed in the main from taxpayer subsidised, anti-social risk taking: in an unsustainable way, banks lent far more than was healthy relative to their capital resources, because they knew that the state would pick up the bill when it all went wrong.
So which of these near total reinventions of banking does Mr King himself favour? Well on this, he is suddenly a little bit bashful.
But he is explicit that the status quo should not be an option. And he lobs a grenade at the commission set up by the coalition to make banking safe:
"In the UK we are fortunate. The Independent Commission on Banking was set up earlier this year. It has outstanding members. I am sure they will lead us to the right solution."