Tuesday 30 July 2013 9:18 pm

Bankers as trapeze artists, central planners and markets

THERE are three ways we can organise banking. The first, which I don’t recommend, is to adopt the pre-2008 model; the second is the current approach, which seeks to micro-manage everything and which will also fail; and the third would be to allow genuine market discipline to be reinstated. 
Under the first approach, there were lots of rules and regulations, many of which had huge effects on behaviour, but they were all about box-ticking and the regulators didn’t really understand what was going on. Central banks, on the other hand, were hyperactive and kept stepping in with lower interest rates to boost the markets whenever anything went wrong, pump-priming the economy and financial system. Alan Greenspan’s Fed even bailed out a hedge fund called LTCM in 1998 in a watershed moment for the socialisation of risk in the financial system. But while banks enjoyed a generous welfare state, they were able and encouraged by the regulators to hold very limited capital buffers and to engage in numerous new practices. They experimented with increasingly complex new instruments and the shadow banking system became hugely important. The traditional capitalist discipline of profit and loss, and the fear of going bust, was replaced by a rush for leverage.
Banks were like trapeze artists in a circus: they were encouraged to engage in ever more crazy acrobatics, safe in the knowledge that if they slipped up they would be caught in the safety net. To make matters worse, they and the authorities were drunk on cheap money and no longer able to assess risk. They became convinced that mad assumptions were in fact safe. Huge moral hazard and massive errors triggered vast bailouts. 
The current model is different. It is focused on creating much less risky and far more boring banks; sadly, it is overreaching, making banks too tame and creating tiers of conflicting and overlapping rules that in many cases won’t achieve much. The new approach is correctly increasing capital and liquidity and reducing leverage, but doing it in a pro-cyclical manner which has reduced credit, for all the protestations to the contrary (and even though Barclays’ deleveraging yesterday will supposedly not trigger any more of this). There has already been an endless list of growth-reducing errors from the politicians and authorities, including the incorrect view that investment banks are inherently riskier than retail banks and need to be ring-fenced in a clunky way, stupid caps on bonuses that will make the financial system less stable, and endless other idiocies, some politically motivated.
The current approach also assumes regulators know best in a very direct way. There is, apparently, an optimal leverage ratio of three per cent, and the right time it needs to happen is 2014, not 2015 – and no, it’s not 2.5 per cent and it’s certainly not 3.5 per cent. Why? The diktat is a combination of central planning, realpolitik, guesswork and a real attempt at trying to find out the best answer. 
We need to adopt a third approach, harnessing the power of competition and genuine market forces to discipline banks, making them serve their customers and ensuring that the risks they take are as rational as possible. Every implicit or explicit subsidy should be removed. Bank accounts should be made portable to maximise competition in retail markets. 
The priority should be to make banks behave more like every other kind of business, for whom the possibility of going bust puts a brake on irrational exuberance. Under properly functioning capitalism, with no government backstops or handouts and no moral hazard, greed is usually counterbalanced by fear. The same must become true in banking. If they knew they could lose their shirts, bondholders would demand as much in equity and capital buffers as they thought made sense. Bottom-up knowledge would be harnessed thanks to trial and error. All banks, regardless of size, need to be able to be dismantled and liquidated in an orderly fashion that doesn’t threaten the rest of the economy if they go bust. Banks that run out of cash should be bailed-in, with bondholders taking the hit. It’s time to bring some real capitalism back into banking.
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