Bad banks must be allowed to fail again

Allister Heath
ONE year after Lehman&rsquo;s demise, there is much we should be grateful for. The economy has shrunk by about 6 per cent, compared to the 25 per cent or so collapse suffered in the US during the Great Depression. We have got off relatively lightly, even though it doesn&rsquo;t feel that way to the hundreds of thousands of unfortunate workers who have lost their jobs. <br /><br />But while much has changed for the better in the City and Wall Street, many problems remain, not least the belief that no large bank will ever be allowed to go bust again. Moral hazard was at extremely elevated levels before Lehman; if anything, it is even worse today. Everybody agrees that there is no chance that any large or even smallish institution will be allowed to go bust. Bondholders, depositors and counterparties therefore don&rsquo;t need to worry about making sure banks keep their risk-taking in check.<br /><br />This is a dangerous state of affairs. There is only one solution: governments must embark on a long-term plan to shift expectations and send out a credible message that nobody in the financial services industry is too big to fail. The answer is not to artificially reduce the size of banks &ndash; instead, it is to force all their customers and investors to be more vigilant, while putting in place procedures to prevent a bankruptcy from causing panic and taking down the whole system with it. <br /><br />First, the government should announce that a more free-market approach will begin in five years&rsquo; time, giving everybody time to adjust. Then deposit insurance should be gradually reduced; this process should be accompanied by a massive advertising campaign telling consumers that they need to make sure their money is safe because they will not be bailed out in the event of failure. This message should be made clear in every single communication that banks have with their customers. This would prevent a return to the bad old days of 2005-07, when consumers only cared about interest rates and put their savings in dodgy Icelandic banks they had never head of, assuming that their money was protected. Just as everybody realises that share prices can fall as well as rise, the same should be true of bank accounts. <br /><br />At the same time, all banks need to be forced to write a living will: a guide to unwinding and liquidating them in a short period of time. A version of this plan is to be announced today by Alistair Darling; while the banks hate the idea, it is hard to see any alternative. There also needs to be revolutionary changes to disclosure practices, with information about liabilities, positions in the derivatives markets and counterparty exposures all available in real-time to regulators. Had the Fed known exactly what Lehman Brothers owed other firms, or the exact counterparty positions by AIG, it would have been much easier to predict what the consequences of bankruptcy would have been. Regulators should also constantly practice how they would cope with a major bankruptcy or the unwinding of another bubble. All of this will cost money and will necessitate some red tape; but another giant bail-out or to the sorts of punitive measures many now want to impose on the City would be much more damaging.<br /><br />No bank must be seen as fully safe or too big to fail; it is time for truly radical action. <br /><br /><br />