The world is still being held hostage by its rotten banks

June 21, 2013 7:29 pm

The world is still being held hostage by its rotten banks

By John Plender

Another financial crisis is probable and it would be much more damaging to the global economy

In the midst of this turbulent summer in the markets, the revolving door at the top of British banking has been spinning unexpectedly fast. At the Bank of England,Sir Mervyn King, the governor, is shortly to be replaced by the governor of the Canadian central bank, Mark Carney. The abrupt recent announcement of the impending departure of deputy governor Paul Tucker preceded the appointment ofCharlotte Hogg, head of retail banking at Santander, as the Bank’s first chief operating officer. In the private sector, Stephen Hester recently found himself brutally ejected from his role as chief executive of Royal Bank of Scotland. Many in the City of London were disconcerted by the timing of the Tucker announcement and the Hester defenestration.Unexpected change is also happening in the regulatory landscape. George Osborne, the chancellor of the exchequer, this week accepted the recommendation of theParliamentary Commission on Banking Standards (PCBS) to review the case forsplitting RBS into good and bad banks, an idea that Mr Hester had opposed. In his Mansion House speech Mr Osborne also proposed the initial sale of part of the government’s holding in Lloyds Banking Group. At the same time an Office of Fair Trading investigation is being launched into competition in banking for small and medium-sized enterprises. The question is whether all this will make the system more robust and keep taxpayers safe from future bankerly folly.

Changes are certainly called for. As Sir Mervyn underlined in his speech at the Mansion House on Tuesday, the UK banking system remains in no condition to make an adequate contribution to economic recovery. There has been some regulatory progress, not least with a new resolution regime to ensure the orderly unwinding of insolvent banks and with the Vickers Commission proposals to ringfence the retail operations of universal banks. Until the commission’s proposals are implemented, though, we will not know whether the implicit subsidy enjoyed by banks hitherto deemed too big to fail has been removed or that banks will no longer be able to call on taxpayers to keep them solvent. Despite much work by central bankers in Basel, few believe that a solution to cross-border resolution and the global cat’s cradle of counterparty risks is in sight.

Meantime the Basel III capital regime is pushing more risk from bondholders on to shareholders, which is healthy. Yet in dealing with large, complex financial institutions the rules for risk-weighting bank assets are insanely complex and distorting. In a speech last year the Bank of England’s Andrew Haldane argued that the regulators use rules that are needlessly complicated – adding that this was tantamount to asking a border collie to catch a Frisbee by applying Newton’s law of gravity to calculate its flight path. He would like more attention to be paid to a simple leverage ratio requiring a minimum level of equity capital in relation to bank liabilities. Yet Basel III’s backstop leverage figure is just 3 per cent by 2019. For a banking system to operate on the basis that a fall of a mere 3 per cent in the value of bank assets will wipe out the banks is simply absurd; all the more so when banks’ risk-management techniques were shown to be hopelessly flawed in the crisis, yet remain substantially unchanged. The dangers here were highlighted when JPMorgan, supposedly the best risk manager in the business, lost $6bn in the “London whale” trading fiasco. Its much admired bosses had no notion at all of what was afoot.

It follows that on current policy another financial crisis is probable. And since it is clear that there is no political will for further bailouts in the US, little at the German heart of the eurozone and limited fiscal capacity for bailouts in the UK, a new crisis would be much more damaging to the world economy. In effect, the UK and much of the eurozone appear determined to repeat the mistakes that inflicted stagnation on Japan for the past 23 years, but with more financial risk.

The recent changes in the UK do at least hold out a little hope of a less horrendous outcome. The PCBS’s call for a review of splitting RBS offers a potential avenue for
reactivating the flow of credit to the real economy. Yet senior Treasury figures worry more about practical and short-term budgetary constraints than the risk of following Japan.

On the issue of leverage the global climate is shifting a little in the direction of sanity, with the Brown-Vitter bill in the US Congress rejecting Basel III and demanding a minimum 15 per cent leverage ratio for the largest US banks. And the PCBS has recommended that political control over the leverage ratio, the single most important tool to deliver a safer banking system, should be relinquished in favour of the regulators. This is surely right. Without it the independence of the BoE is compromised, as is its ability to secure financial stability.

Also encouraging is that the new UK regulatory mechanisms appear to have been robust in dealing with the crisis at the Co-operative Bank and identifying a wider capital shortfall across the banking system.

That said, Mr Carney faces a formidable set of challenges as incoming governor of the BoE. The balance sheets of Britain’s largest banks still amount to 400 per cent of the economy, which is too big for comfort. Their culture is rotten. Mr Osborne has clearly indicated that he regards the task of stabilising the economy as lying primarily with the central bank, so Mr Carney will be blamed if a decent recovery fails to materialise in the face of a heavy fiscal headwind. The interaction between monetary policy and the BoE’s new financial stability function is uncharted, risky territory. The manageability of the newly enlarged BoE is also an issue.

Nor is the wider economic context helpful. Market jitters this week over the Federal Reserve’s newly declared intention to reduce the pace of its asset-purchasing programme shows investors are worried about the US recovery as well as the bond market. The eurozone economy is, in the words of Bill Gross, managing director of bond investor Pimco, a basket case. Banks everywhere are freighted with too heavy a burden of potentially toxic sovereign debt, leaving them vulnerable to rises in bond yields, especially in Japan. So while recent events in banking are modest cause for optimism, both the UK and the world remain hostage to unreconstructed bankers and their powerful lobbyists, to whom government ministers are extraordinarily deferential. The global economy and taxpayers everywhere are still seriously at risk.