WITH Alistair Darling preparing to unveil some of his thoughts on shaking up financial regulation, it is time to get back to basics. The following are some of the lessons we have all been forced to relearn over the past few months; any proposed reform should be assessed in lights of these simple realities about any banking system.
Banks all suffer from an inherent weakness: they borrow short-term (from customers who deposit money in their bank accounts) and lend long-term (to homeowners and businesses). They lend out the vast majority of their deposits at any one time, keeping few liquid assets. Even the best-managed banks would collapse if enough depositors were suddenly to seek to pull out all of their money. This explains three things: why we are paranoid about irrational bank runs; why one reason deposit insurance is thought to be needed is that it makes people less prepared to queue up in front of branches; and why central banks are said to be required to act as lenders of last resort, bailing out healthy banks that suddenly face a liquidity crisis caused by a run (some contest all of these conclusions, but for the sake of this column I will take the received wisdom at face value).
We now know banks can also fall prey to another kind of liquidity crisis: relying on the continuous rolling over of commercial paper (rather than deposits) to fund lending becomes lethal if money markets stop working. Clearly, banks should stop doing this; there is a place for depositless lending institutions such as pure credit card firms but they will probably go bust every couple of decades when the markets suddenly seize up.
Two newish arguments for intervention are now also being made. The first is that financial institutions – especially insurance companies, investment banks and firms operating in the credit default swap (CDS) market – create huge amounts of counterparty risk. If a firm goes bust, many others suffer crippling and possibly fatal losses. This is why AIG was bailed out rather than allowed to go bust a la Lehman Brothers. Another variant of this argument is that any very large bank will create large amounts of counterparty risk, and is therefore too large to fail.
Some are therefore suggesting that banks should all be broken up and forced to remain small. Not so. Lehman going bust didn’t destroy the system; what did was the realisation of the magnitude of the problem facing banking, and the immediate freezing up of the money markets. Many feared that the unwinding of Lehman’s CDS positions would destroy everybody else; but the process went much more smoothly than feared.
The real problem at the time was the opaque nature of relationships and the fact that CDSs were not exchange-traded. Had everybody understood who AIG’s counterparties were, and how exposed they were, a more rational decision could have been taken. We eventually found out that few, if any, of the counterparty hits would have been fatal; it would have been much cheaper to bail out one or two the counterparties than to nationalise the whole of AIG.
Much greater transparency would allow failed banks to be wound down without panic. Counter-party risk is a real issue; but it hasn’t made every big bank too large to fail. Let us hope Darling as well as the Tories come to see this.