Saturday, January 22, 2011

Finance can not be reformed - it just needs to be modernized

Jeremy Warner ran an interesting column in the Telegraph in which he argues that there is no silver bullet to bullet-proof banking against a once in a hundred year crisis like we just experienced.  Readers of this blog know that current asset-level disclosure is the silver bullet.

How does Mr. Warner's observations stand up to disclosure?
Is there really any point in the UK Independent Commission on Banking? It’s chairman, Sir John Vickers, is due to give a speech in London on Saturday, airing some further thoughts on how the banking sector might be restructured – subsidiarisation seems to be the ICB’s latest hobbyhorse. As an exercise in academic thinking, jolly interesting it all is too. But will any of it have any practical import?
I guess the answer to this is still that it might do. The ICB is a Government sponsored exercise, so ministers will presumably feel bound, at least to some degree, by its recommendations. What’s more, they staffed the commission with some quite feisty intellectuals, none of whom look likely to settle for cosy and consensual, status quo thinking.
Thanks to what they’ve written on these issues, we already know what some of them think. Martin Wolf, chief economic commentator on the Financial Times, believes the Basel III proposals on capital reform don’t go nearly far enough, while Martin Taylor, former chief executive of Barclays (you shouldn’t think this makes him banking establishment, for even when at Barclays, he was never that) seems to be an outright Glass-Steagall man. As for Clare Spottiswoode, or the “laughing regulator” as she used to be known when she was overseeing the gas industry, we know she’s all in favour of radical structural reform; it was she who forced the breakup of British Gas.
Before proposing a solution, each of these individuals is likely to test a proposed solution against a series of questions: "would it have prevented the credit crisis by treating the cause or does it treat a symptom?" "will it reduce moral hazard in the future?"  "is it easy for regulators to implement?"
I’ve no doubt the Commission will influence the debate, but I don’t see it determining the outcome. The Government made itself something of a hostage to fortune by appointing such an independently minded group of individuals; unencumbered by the compromises of government, their recommendations have plenty of potential to embarrass.
Actually, the Commission has the opportunity to recast the entire discussion.  When the focus is on the issue of disclosure, investors also have a say. 
If, for instance, the Commission recommends root and branch breakup along business lines, will the Government implement it? As long as the international consensus remains in favour of universal banks, this seems rather unlikely, for it would in effect, remove one of the UK’s leading international industries from the international stage. Some banks would redomicile to avoid the Commission’s chopper.
With current asset-level disclosure, there is no need to break-up the banks.  If a bank is unwilling to provide this disclosure, the UK and the rest of the world are better off with their leaving. 
Part of the problem with the ICB is that it was never made entirely clear what it is for. Was it merely an exercise in government procrastination, or playing difficult issues off into the long grass? Is the purpose to find reforms that would prevent future banking crises, and iron plate the system against future risk, or is about finding mechanisms for dealing with a crisis in more optimal ways, without recourse to the taxpayer? And if issues such as capital adequacy are being decided internationally in Europe and elsewhere, does that mean the Government finds them insufficient, and wants even more?
None of these questions have been properly answered, so there is a real danger of the Commission going off all over the place. Personally, I think it madness to try and bullet proof banking for a once in a one hundred year event, if only because it is impossible. Markets are ingenius things, and they will find some way around whatever rocks are put in their way. Furthermore, the idea of a banking system without risk is just plain silly. In such circumstances you would also get no growth.
The beauty of current asset level disclosure is that it does not mean there will be no risk in the banking system.  Quite the contrary.  What current asset-level disclosure brings is the ability for investors and competitors to independently assess the risk of a specific bank and to make their investments accordingly.  This is what is known as exerting market discipline. 
It may be possible to create resolution regimes which better insulate the taxpayer from banking crises, but the idea that governments can be entirely removed from their traditional lender of last resort role strikes me as cloud cuckoo land. It’s a holy grail, and therefore by definition a hopeless endeavour.
Actually, the combination of competitors and market analysts are likely to identify a bank taking excessive risk well before there is a need for the government to step in.  Once identified, the pressure will be on bank's management to reduce this risk or face a) a falling stock price and b) less access to capital through the inter-bank market.
I wish Sir John Vickers luck in his search for the silver bullet, but I don’t rate his chances.
Actually, your humble blogger thought someone should hand Sir John Vickers and the Commission the silver bullet of current asset-level disclosure.

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