Talk is cheap. Action is expensive....That is why this blog challenged Mr. Diamond to lead the global banking industry and provide utter transparency into Barclays' current asset, liability and off-balance sheet exposure detail on an on-going basis.
Mr Diamond is one of those clever investment bankers who, as my colleague John Kay has noted, now manage most important global banking institutions. He focused on rebuilding trust....
Mr Diamond argued that banks need to show they support growth, accept responsibility for what has gone wrong and “become better and more effective citizens”....
So why am I cynical? I look at incentives and behaviour, not words....
It is not enough for banks to accept the principle of “strong regulation”, as Mr Diamond does. We need to see changes in how banks manage themselves if we are to believe in protestations of reform.This is the first area of group think. The idea that there is an overlap between strong regulation and bankers making voluntary changes that show they have "reformed".
On a Venn Diagram, this is the empty set as there is no relationship between strong regulation and bankers voluntarily reforming.
If bankers were the voluntarily reforming type, they would have reformed during the Great Depression and we would never have had the financial crisis that began on August 9, 2007 and the Great Recession.
First, bank managements must stop targeting returns on equity that are unadjusted for risk, particularly ones as high as 15 per cent, as I have argued on the Wolf Exchange. The easy way to achieve such targets is to raise leverage – a practice concealed behind the smoke screen of risk-weighting of assets. Robert Jenkins, a member of the financial policy committee of the Bank of England, puts it well: “Return on equity is the wrong target. Over the past 10 to 15 years it has helped to make many bankers rich and loyal shareholders poor. Moreover, it prompts banks to fight to keep loss absorbing capital low. This makes their enterprises vulnerable and our financial system fragile. As the key driver of bank behaviour it has to go.” Amen.This is the second area of group think. The idea that bankers' compensation and related risk taking occurred in a vacuum.
Regular readers know that this idea completely ignores the role of the global financial regulators. The global financial regulators had a responsibility and the authority to prevent bankers' compensation from putting the financial system at risk.
The fact is that without the approval every step of the way by the global financial regulators, bankers could not have put the financial system at risk.
Second, banks should welcome attempts to raise capital and lower gearing, over time. This is also the best way to make Mr Diamond’s intention that we will never again need to rescue banks at all plausible. As things stand, this is “time inconsistent” – a promise unlikely to be fulfilled. Better capitalised banks would be more resilient. Furthermore, this must be real capital against actual assets. The turmoil in markets for supposedly safe sovereign debt shows why risk weights can be so dangerous.This is the third area of group think. The idea that bank capital is anything other than a meaningless, easily manipulated number.
This blog has repeatedly debunked this example of group think by pointing out
- a parent would not use it to assure their child that the child's savings would be save at the bank,
- bank capital includes retained earnings which in turn represents the accumulation of net income and net income is easily manipulated by the assumptions made about the size of the losses in the bank's loan portfolio,
- market participants do not use it when they determine the solvency of a bank as they look at the market value of the bank's assets less the book value of its liabilities, and
- Walter Bagehot's observation that a well-run bank needs no capital and no amount of capital will save a badly run bank.