Bank reforms missing the big picture

Allister Heath
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s hard to know whether to laugh or whether to cry about the latest round of banker-bashing, fuelled as ever by Vince Cable, who always knows exactly what the public wants to hear, though rarely what the economy actually needs. The biggest problem, as ever, is that the argument about the Independent Commission on Banking’s proposals has been framed to mislead. On the one hand lies a supposedly “unreformed” banking industry and its lobbyists who are trying to maintain this supposedly happy state of affairs to “keep their big bonuses”; on the other is an enlightened Commission which is going to propose the “most far-reaching reform to the industry for a generation”, and which bravely wants to “split” (note the inaccurate nod to Glass-Steagall) the “ultra-risky casinos” from the lovely “utility” banks. Who could possibly oppose any of this, barring idiots, greedy fools or paid lackeys?

Virtually all of these assumptions are nonsense; sadly, I don’t have space to address them all. The biggest untruth is the view that those who oppose or doubt a particular reform oppose all changes. Equally wrong is the view that these are the first significant reforms: banking is already undergoing a massive regulatory revolution, with rules on everything from derivatives to pay changing drastically. The changes are so huge that McKinsey & Co estimates that, without drastic action, investment banks’ returns on equity will drop to seven per cent from 20 per cent. That is below their 9-11 per cent cost of equity, making most banks non-viable if they fail to shrink or restructure. Most of this will be caused by the Basel III accord and other shake-ups; none of this is surprising to those who actually follow the financial world, rather than spout demagogic and populist nonsense to win votes. Some of the reforms have been good; return on equity was artificially inflated by low capital and liquidity, and high leverage levels that would never have existed in a truly free market. Many other reforms or proposals have been disastrous and are costing jobs and growth.

Ringfencing would not have stopped sub-prime lending, nor prevented the demise of HBOS, Bear Stearns, Lehman Brothers or Northern Rock.

The real, truly big reform we now need – and this is in motion in the US, the Eurozone and the UK – is to finalise resolution procedures to allow banks to fail in an orderly, organised manner that doesn’t cripple the entire economy, destroy innocent bystanders or trigger chaos. Even giants wouldn’t be too big to fail under such a system. Such measures already exist with airports and nuclear power plants; they are well established with smaller US retail banks. We also need systems so that bail-ins become automatic, with debt turning into equity if things go wrong. The aim must be to banish taxpayer assistance, eliminate bail-outs and put in a place a structure that makes banks think and behave like all other firms, accounting properly for risk and reward. This would get rid of moral hazard and faulty decision making fuelled by the knowledge that the authorities will always step in to save firms or the system if things get too crazy. Barclays, to its credit, is nearly there; everybody else must follow suit.

There are three choices: the corporatist, bail-out culture of the past; the destructive, anti-City, regulate regardless of cost, present mood; or a move to something closer to real capitalist discipline. I vote for the latter.
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