Debate about how best to regulate the financial system is well and truly underway. It has been observed that if a bank (or similar financial institution) is too big to fail it is too large to live.
The issue of “moral hazard” has been highlighted by the rapid return to profitability of banks that accepted taxpayers’ bailout money not so long ago, with consequent payment of large bonuses which may be difficult legally to prevent.
No lesser authority than Paul Volcker, America’s all-time champion central banker, wants to separate commercial banks from investment banks, a return to the arrangements of a simpler time.
This would rather neatly separate different types of financial activities — presumably improving managerial and board focus — and make current financial conglomerates smaller.
Commercial banks would be closely regulated and bailed out or forced into shotgun marriages if they were in danger of failing. Managers could be expected to behave, and be paid as, old-time commercial bankers. Retired commercial bankers could be pressed into service if the current generation of bankers was uninterested in such a dull, moderately paid, career.
Investment bankers would be allowed to take risks with their balance sheets, gearing up to increase returns if they wished. The key point is that it would be made crystal clear that no bailout could be expected — indeed the enabling legislation might specifically ban any official bailout or marriage brokered by officials.
Sadly, despite Volcker’s stellar reputation, this idea seems not to be gaining traction in the USA, mores’ the pity.
It is hard to imagine APRA’s John Laker knocking on Macquarie Bank’s front door and saying something like “I’m here to break you into a dull commercial bank and a racy investment bank. Stop what you are doing until I approve a new business plan.”
There are massive vested interests at play here, and highly paid bankers are famously good at duchessing poorly paid officials and politicians. Whatever the bureaucrats and pollies say, they cannot avoid a sneaking feeling that the bankers must be smarter than they are, and which modern official or politician can argue confidently with the verdict of the market? (Kevin Rudd and Ken Henry perhaps excepted.)
Martin Wolf of FT fame discusses the challenge of managing the “gigantic cuckoo in our nest.” He concludes, consistent with Volcker: “Either we impose a credible threat of bankruptcy. or institutions we have to support are made safer, or, better, we have both of these.”
“Open-ended insurance of weakly regulated institutions that take complex financial institutions that take complex gambles is intolerable. We dare not return to business as usual. It is as simple — and brutal — as that.”
John Gapper this week discusses what should happen to Goldman Sachs.
Locking up a high proportion of bonuses until ‘partners’ retire is one possibility, with strong clawback provisions in case of losses caused by anything really but certainly bad risks gone wrong.
Convincing people that Goldman is a public utility that operates in the public interest might be more attractive but unlikely to succeed.
But the main message is clear — Goldman is in the class of organisations that should be allowed to fail.
Goldman Sacks has now paid back the money it received from the TARP program in the US (did it in June). So has JP Morgan. If these banks were allowed to fail, a lot more people would have lost their savings and the world economy would have been in even more dire trouble. The government bailout, while pretty crazy at the time, has definitely helped.
The “moral hazard” created by the Government guarantee is a pretty big concern, but there are ways of encouraging it to be short term…applying high interest rates to bailout funds, or restrictions on renumeration of executives while accessing the TARP (which is already happening). These things encourage the businesses to reform their practices and have decent risk management.
There is no doubt that the US needs to improve it’s financial system regulation (implementing the BASEL 2 standards like Australia would be a good first step), but removing investment banking from deposit taking institutions will just mean the banks will be severely limited in their competition for funds to write loans for mortgages, invest etc.