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Nobody Is Too Big To Fail

Jeremy Hetherington-Gore Unleashed
08 November, 2009

I decided to give the G20 St Andrews meeting on Friday and Saturday a miss, since nobody thought anything would be agreed even in advance of the meeting, and sure enough, it wasn't. The closing communique is bland even by the standards of those always very banal documents.

The highlight of the occasion was Gordon Brown's ringing declaration of war against the banks, something not without irony in a week when his government splashed out another fifty billion pounds it hasn't got in their direction. But of course everyone knows that there won't be any new taxes on banks: it's important not to damage them further when they are just starting to get back on their feet. This was a blatant piece of electioneering, aimed at taking advantage of popular indignation about bankers' bonuses, and should make for a nice blip in the government's opinion poll ratings.

The other leaders present listened politely, but there was no agreement on action against the banks. 'We call on supervisors to ensure that banks retain, as needed, a greater proportion of their profits to build capital to support lending; -- to ensure that compensation policies and practices support financial stability and align with long-term value creation; we commit to incorporate urgently within our national frameworks the FSB standards, and call on firms to implement these sound compensation practices immediately.' That was the nearest the meeting could come to positive action.

What is worrying, though, is that there has come to be a consensus at G20 level that banks can't be allowed to be: 'Too big to fail.' Hmmm. Meaning that they will try to make banks smaller (what Gordon and the EU are doing in the UK market). But who says they are too big too fail? They aren't. What the politicians mean is that they can't handle the political backlash of a major bank failure. They say that a major failure would cause a global financial collapse, and therefore they have effectively nationalized large swathes of the banking sector.

What nonsense! The failure has come from the politicians, who have failed to allow failure, and are now having to deal with the consequences of their folly.

Let's pick it apart a little. There are three constituencies who can suffer in a bank failure: the depositors (who are mostly also borrowers through mortgages); the shareholders; and the wider financial community, who are intricately linked with each other and a failing bank through inter-bank lending.

We can immediately dismiss the shareholders as an issue: they will lose their money whether a failing bank is nationalized, saved, or fails. The depositors are protected in most countries by industry or governmental deposit insurance schemes, and the few countries that didn't have such schemes have now made sure to put them in place in response to last year's panic. That leaves the inter-bank market, and that's where governments fear meltdown. But it has to be repeated time and time again that the inter-bank market has become a risk only because governments have allowed moral hazard to reach such proportions through their own actions.

There will be some useful improvements as a result of last year: counter-party settlement risk is being dealt with in most sectors by having independent, separately capitalized settlement agencies, as is currently happening in foreign exchange, and has already happened in most parts of the securities markets; equity capitalization will be improved; the rating agencies will be subject to much greater scrutiny (really they should be abolished and turned into a global organization, perhaps as part of the WTO); 'living wills' or disaster scenario planning will become de rigeur for large banks and should be enforced by central banks; and the mechanisms for prudential banking supervision will be much improved in many countries, including the UK and the USA.

Having encouraged all these steps, governments should then fold their arms, stop interfering, and make it absolutely plain that they will never again save a bank. Of course they will have to continue to offer liquidity to markets when it is needed, and they should help banking takeovers with tax breaks and liquidity, as used to be done in cases such as Continental Illinois. But please, please, let a big bank fail, and preferably as soon as possible. Once the nasty medicine has been drunk, the industry will pull itself together and start to behave in a grown-up kind of way. Right now, bankers are like drunken teenagers at a party where the bar is open all night and the grown-ups have gone to stay with friends. What do you expect will be the result?

Of course it's not going to happen. Politicians will continue to meddle, trying to construct a banking sector that cannot fail, bankers will continue to take the money and ignore the advice, there will be another credit boom, and there will be another bust. The only unknown is when.


About the Author

Jeremy Hetherington-Gore Unleashed

Jeremy tackles the difficult issues head on!


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