Although still somewhat sketchy, Barack Obama’s plan to ban state-backed retail banks engaging in casino activities is the first major initiative to tackle the biggest problem thrown up by the financial crisis: banks that are too big to fail. He is, then, calling time on the credulity that politicians on both sides of the Atlantic have displayed towards the financial sector.
The case for breaking up the banks is overwhelming. Morally, it is repugnant that taxpayers underwrite bets made by a bank with its own money. Financially, the effects of an implicit blanket guarantee – a de facto subsidy because it lowers banks’ borrowing costs – are perverse and destabilising. It has led to gross misallocations of capital (for example, bloated employee bonuses), an inflation of risk appetite and a running-down of banks’ own buffers for absorbing losses. The result is that governments are guaranteeing banking sectors that exceed their GDP and having to bail them out in ways that only makes banks even bigger and more likely to fail. This is unsustainable.
The response over here to Obama’s announcement has been unenthusiastic. Alistair Darling said separation wouldn’t have prevented the collapse of a retail bank like Northern Rock. The Financial Times leader said separation is a “Maginot Line” as there will still be many non-bank structures in the financial sector that are too big to fail. The FT endorses higher capital requirements instead, as does the government, along with living wills.
Banks, however structured, can collapse for a variety of reasons. It’s precisely because of this that the essential ingredient of any reform package must be a reduction of taxpayers’ exposure. Moreover, the lament that so much of the sector is now too bloated and complex to be allowed to fail is a counsel of despair; such fatalism in regard to the public sector is unimaginable. A successful confrontation with Wall Street/the City on bank separation would send a powerful signal to the entire sector that the era of political bowing and scraping is over. This, not reforming the banks on their terms, would extinguish the complacency that breeds moral hazard.
If anything is a Maginot Line, it’s the faith placed in higher capital requirements. Lehman Brothers had a tier one capital ratio of three times the regulatory minimum five days before it collapsed. Although the Basel committee is devising more stringent requirements, it’s unlikely they will be high enough to absorb the losses of the weakest bank in a crisis, which, in an interconnected financial system, is what they would have to do if they are significantly to reduce systemic risk. The Economist has estimated that, in the last crisis, Merrill Lynch would have needed a capital ratio of around 23% of risk-adjusted assets to absorb its losses. The committee is not going to recommend anything that high as this would choke the sector. Capital requirements are part of the answer, but a limited one.
Don’t get too excited about living wills, either. Lord Myners has said that they will achieve much the same as bank separation, without the disruption. However, in a speech last month, he didn’t say whether they would identify which units of a bank would be rescued by the state and which would not. All he said was that they “would facilitate wind-down without exposing the tax-payer to yet more risk” (italics added), and that’s about as far as his article in the Guardian today goes as well.
His lordship’s sophistry is deeply dismaying. The collapse of the banks was not just a financial crisis but a crisis of democratic politics. It revealed to the voter/taxpayer the extent of their political representatives’ dereliction of duty during the boom and the staggering scale of what those representatives were committing to underwrite without any real discussion. Reform of the banks must firmly re-establish government as the defender of the public interest against the sectional, lest politics becomes nothing more than an oligarchy in the service of an oligopoly.