Regulators are founding their bank-capital reforms on the premise that there is such a thing as an orderly panic. Instead, they should be working on how to prevent the panic happening in the first place. The answer could be very simple, but probably not very popular.
Part 2: Don’t panic!
It will have been abundantly clear from my last blog that I am not a professional banker. It’s why I try to explain things to my reader (and myself) in brutally simplistic terms. And I am going to take the same approach now.
If the heart of the regulatory approach to the new banking world order is about saving ordinary depositors from being wiped out in a crisis, on the one hand, and removing the ‘moral hazard’ of banks’ relying on the central bank/taxpayer to bail them out when they misbehave, on the other, then it strikes me the simpler the approach, the better. It was over complexity that caused the 2008/9 crisis in the first place so logic would dictate the solution must be simple.
But the bank-run countermeasures regulators are putting forward today are anything but simple. Taking place is a deeply granular and tortuous debate about bank capital and liquidity coverage ratios - that will need to be calculated via an assessment of the risk of every loan a bank makes.
An orderly panic?
Since the taxpayer-funded bail-outs of 2009, regulators have – rightly - become deeply exercised by banks’ capital structures. In other words, who it is that takes the first hit when a bank fails (answer: not depositors or taxpayers). They picture a kind of utopian bank failure where – once triggered - the capital structure collapses neatly into a tidy heap. In this neat and tidy scenario, first of all the shareholders lose their money, then the hybrid debt holders lose their money, then the bond holders and then the senior debt holders. Depositors, in the regulators’ eyes, will be covered by an insurance scheme, contributed to by banks in the good times. Not a tax-funded bail-out in site.
However, as we all know, life doesn’t work like that. When someone shouts “fire!” everybody runs for the door at the same time. And it’s the same with banks. When people lose confidence in a bank’s ability to service its obligations – they panic. It’s human nature. And who has ever seen an orderly panic? Everything becomes worthless all at once.
Santander to the rescue
And that is what happened with Banco Popular in Spain last year. And if it wasn’t for Santander, the Spanish knight in shining armour, riding to the rescue at the last minute, the depositors would have been hit too. Well, they wouldn’t have been hit because – once again – Don Quixote the taxpayer would have lumbered along on his aged donkey and bailed everyone out again. In short, despite all the deep thinking – wailing and gnashing of teeth – about capital adequacy, no government has actually found a way of protecting depositors in a real-life crisis. Except of course by resorting to the usual central bank of mum and dad.
The question I will ask the guests on my panel in June is this: is there a simpler solution that could bypass all this highly detailed tinkering with bank capital structures? Tinkering that, when push comes to capital shove, is unlikely even to make a difference.
Match assets to liabilities
Once answer could be narrow banking. Given that the ultimate goal is to protect depositors, why not make a rule that banks should only use their customers’ deposits to invest in highly liquid assets – like government bonds? Full stop. In the event of a bank run, these government securities can easily be converted to cash in order to pay back nervous customers. If a bank wants to lend to companies and individuals for the longer term then it will need to use longer-term liabilities in order to do so – or their own retained profits. Yes, profit margins will shrink, but there will also be zero chance of big debt-fuelled explosion down the line that wipes out innocent depositors.
And if banks do want to make risky bets, then they can do it by using their own profits, or by using equity raised from investors – who know the risks and invest on that basis. So, rather than come up with some ball-park capital adequacy figure based on a highly complex evaluation of assets and their relative risk, regulators could simply segregate which liabilities can be used to fund which assets.
Simple bank necessities
I know, I know, it’s all too simplistic. And no, I’m not a simpering socialist – far from it. I agree, it will hurt banks’ bottom lines, which, in turn, hurts ordinary people and small businesses - who can no longer get cheap mortgages and readily-available business loans. Smaller profits will also hit shareholders, and – because smaller profits mean less tax – the exchequer too. Fewer people will be employed by a shrinking financial sector – depriving the exchequer of yet more tax, and luxury shopkeepers and the owners of gourmet City restaurants of lots of wealthy customers.
Maturity transformation performs a vital social service according to, among others, Nobel award-winning US economist, Paul Krugman. He sees banks’ ability to allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets as a socially productive activity. “It allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments,” Krugman says. “If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”
I agree, Paul, I really do. But I am always suspicious of those people who believe in having cake, and eating it at the same time. And I also like simplicity. If the financial system hadn’t got so darned complicated in the first place – and people hadn’t been trying to eat so much cake and have it too - we wouldn’t have had a crisis. And there’d have been no need for a decade of regulatory hand-wringing and extraordinary monetary policy.
Does anyone have any other answers? Do please get in touch. The panel debate is on 19th June at 11.10 in central London. More details here.