Banking Reform

Society needs banks, but is not currently well served by them.  They are abusing their economic power:

The finance sector continues to increase the wealth of its employees and shareholders whilst putting the rest of society at risk; the financial crisis of 2007-8 could easily be repeated.

Big banks are regarded as being ‘above the law’.

Recent writings on these subjects have highlighted the gravity of these problems and have suggested some solutions.  The time to implement those solutions has surely arrived, if politicians can agree.  A healthy retail banking system is essential for a modern market economy (3.2.7).  Governments cannot afford to let it collapse because of the resulting damage to individuals and corporations in the ‘real economy’; that was why Presidents Bush and Obama authorised the Troubled Asset Relief Program (TARP).

A recent book, The Bankers’ New Clothes by Anat Admati and Martin Hellwig, was reviewed in Bloomberg Businessweek on 22 February and was the subject of the article Running on Empty in the Wall Street Journal on 1 March.  The book highlighted the fact that banks are able to take very high levels of risk in relation to the value of their share capital (equity) because both the management and the shareholders know that the government would always bail them out; it suggests a remedy – obliging the banks to run with a higher proportion of equity funding compared to their levels of borrowing, perhaps returning to typical post-war levels of 20% equity.  This would mean that retail banks would not fail unless more than 20% of their loans went bad, as compared with the pre-crisis (and current) situation where, as the Wall Street Journal puts it, “if only 4% of the bank’s loans fail, the shareholders are wiped out, and the bank cannot pay its debts”.  Both reviews support the conclusion that the book’s proposed solution would not unduly damage the banking sector and would protect the rest of society from a lot of risk.  And if shareholders knew that the government would be less likely to bail them out they would exercise greater governance over banks; this is a more market-orientated approach than increased government regulation of the banks.

As reported by the BBC on 11 March – the day when the Banking Reform Bill is being debated in Parliament – a British Parliamentary Commission has recommended greater “loss absorbency”, by increasing shareholder capital.  It is also asking for a “firewall” to separate investment banking from retail banking.  Investment banking is more risky than retail lending because financial instruments like derivatives allows bets where the investor stands to lose much more than the value of the original investment.  The Basel III rules only require a ‘leverage ratio’ of 3% by 2018 (and it is reported that some banks are struggling to meet that target).  Several authorities believe that this figure is inadequate; it means that investment banks would be allowed to expose themselves to a risk of 33 times the value of their assets – so the proposal to separate them from retail banking would significantly help the latter is to be more robust.

The continued fragility of the banking system is leading to calls on both sides of the Atlantic for society to take greater legal powers to prevent a recurrence of the 2007-8 financial crisis.  Such calls, though, sound hollow in the face of last week’s astonishing statement by the U.S. Attorney General that “Banks are too big to jail”.  He made this statement before a Senate Judiciary Committee when explaining why he is not prosecuting HSBC for money laundering, saying that “if we do prosecute ….  it will have a negative impact on the national economy, perhaps even the world economy”.

The above Bloomberg article mentioned that “Two national movements—the Tea Party and Occupy Wall Street—flourished in part out of frustration with Wall Street’s privileges, and its failures”.  These two movements are on opposite sides of the political spectrum, so it might be thought that a bipartisan approach would be possible in Congress.  There would also be huge popular support for meaningful banking reform.  It would therefore seem that politicians should be able to push through a solution, but some are arguing for a continuation of the status quo.  Some senior politicians had previous careers in the finance sector, and might therefore be sympathetic towards its desire to receive continued taxpayer underwriting of its risk-taking and corresponding bonuses.  Another factor is the role of money in politics (6.4.5), where lobbying and campaign contributions can exercise undue influence over politicians who should be prioritising the interests of the population as a whole.  Voters should watch carefully.