All can fail: my new manifesto for the banks

Allister Heath
REGULAR readers of this column will know that I am no fan of many of the proposals being cooked up to reform the banks. I have opposed Barack Obama’s plan to ban retail banks from engaging in proprietary trading; George Osborne’s support of Glass-Steagall, which would break up commercial and investment banks; and Alistair Darling’s 50 per cent super-tax on bonuses. None of these policies would prevent another crisis – yet all would weaken the City and destroy jobs here in London.

So today, instead of criticising everybody else’s plans, here are two ideas of my own, both more in line with free-market principles. The goal should be to protect taxpayers – no more bailouts, ever – while maintaining the efficiency and competitiveness of the City of London. Two myths need to be destroyed: first, that there is such a thing as “too big to fail” (a state of mind which encourages risk-taking through the promise of a bailout); and second that only the government can recapitalise an insolvent bank.

Instead, we need two revolutionary reforms: a new “all can fail” manifesto, based around a new resolution process to wind down insolvent firms without disrupting the market; and a system to automatically convert debt into equity at troubled banks, helping to reduce the risk of failure in the first place. Modern financial giants are the heart of the economy: if one or several of these interconnected firms were suddenly to stop functioning, we would be faced with a catastrophic systemic crisis: thousands of employers would go bust, payrolls would go unpaid, ATMs would stop working, markets would cease to function and the economy would collapse. Clearly, therefore, giant banks are different beasts to most other businesses.

But this doesn’t mean that they should be viewed as “too big to fail” – rather, it means that we need to develop a new resolution mechanism to allow them to go out of business – wiping out shareholders and bondholders – without abruptly halting their operations and hence endangering the financial system. It is a reflection on the incompetence and inadequacy of our bankruptcy law that we still seem to believe that massive financial institutions should be dealt with in exactly the same way as the local corner shop.

As Sheila Bair, a US regulator, has pointed out, bankruptcy is designed to protect the interests of creditors, not to prevent a meltdown when a systemically important financial firm gets into trouble. For banks, bankruptcy triggers a rush to the door, as counterparties to derivatives terminate contracts, net out exposures, and sell collateral. Instead, we need a process that provides for continuity in functions while a special body of administrators undertake an orderly transfer or unwinding of the firms’ positions. There is some research going on in this area, albeit not enough. The government’s call for “living wills” would help to achieve this; big firms should also make greater amounts of information available to the authorities, including all their counterparties.

My second major reform would make all banks more resilient and substantially reduce the likelihood of failure. All banks that hold insured deposits would have to issue a large amount of contingent core Tier-1 capital (since Lloyds sold some last year, they are known as CoCos). This is debt that automatically converts into shares if the bank’s cushion of equity capital (the key buffer against insolvency) falls below a certain threshold, shoring up the balance sheet. Bondholders get hit – they end up holding depreciating shares – while shareholders get diluted. This threat would incentivise investors to force management to be disciplined and preserve capital. The bank would have to pay a high interest rate on the CoCos to reflect the risk of conversion into equity; it would thus have another incentive to be prudent to minimise this cost. If banks had to issue CoCos worth five per cent of all assets, their chance of ever going bankrupt would be drastically minimised.

While they require some government intervention, my proposals are in tune with capitalist principles. They would reintroduce individual responsibility, protect taxpayers, ban bailouts and make institutions pay an appropriate cost for their capital, while preserving their freedom over size, activities and pay. So forget about too big to fail: from now on, the new catchphrase is “all can fail.”