In his speech, Mr. Haldane observes
For me, the crisis was instead the story of a system with in-built incentives for self-harm: in its structure, its leverage, its governance, the level and form of its remuneration, its (lack of) competition.
Avoiding those self-destructive tendencies means changing the incentives and culture of finance, root and branch. This requires a systematic approach, a structural approach, a financial reformation.I agree that we need a systematic approach, a structural approach, a financial reformation.
The question before you start to propose a systemic approach, a structural approach, a financial reformation is what was the necessary condition(s) that had to exist for all of these in-built incentives for self-harm to undermine the financial system?
The necessary condition was and still is that the global financial regulators allowed opacity to occur across wide swaths of the financial system.
Had there been transparency in all the currently opaque corners of the financial system, including banks and structured finance securities, would these in-built incentives for self-harm resulted in the financial crisis that we experienced?
Clearly, the answer is no.
It is important to identify the underlying cause of the financial crisis so that you know the financial reformation addresses it. This is necessary so that you know the the reforms being implemented reverse the long regulatory race to the bottom and replace it with a race to the top.
I want to argue that we are in the early throes of such a financial reformation. And that this will help to deliver a more socially useful banking system.
Let me mention some of the more important of these reform strands. These fall into five categories – the five “c”s: culture; capital; compensation; credit; and competition.Cute.
It is easier to will the ends on these issues than it is to divine the means. How exactly do we change banking culture?Make the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
As Justice Brandeis observed, sunshine is the best disinfectant. And nothing brings more sunshine to banking than ultra transparency.
Ultra transparency brings about instant culture changes as for example, no banker would think of manipulating Libor because everyone could see what they were doing.
So I want to give you some concrete, practical proposals for change. And I want to tell you not only that these should be delivered but that they will be delivered.
Individually, none of these reforms may sound like a game-changer. A number lack the pizzazz of a “tar and feathers” strategy. But taken together, I think they amount to the most radical agenda of financial reform for 80 years. Importantly, I also think they will work.First, saying these reforms amount to the most radical agenda of financial reform for 80 years is essentially setting the bar on the ground and stepping over it. Prior to the current financial crisis, we hadn't had any need for financial reform since the Great Depression. [This argument didn't work for President Obama either when he talked about the Dodd-Frank Act.]
Second, all of these reforms are game changers in the way that rearranging the deck chairs on the Titanic was a game changer.
A true game changer is a reform that allows the governments to end all of the programs that were put in place to put the financial markets on life support since the start of the financial crisis.
First, and perhaps foremost, culture. We are about to undertake structural reform of the global banking system, perhaps the largest since the 1930s. In the US, this is the Volcker rule. In the UK, it is the Vickers proposals. Most recently in Europe, we have had the Liikanen plans.
Though different in name, these structural reform proposals contain a common thread. They will seek a separation – or at least a ring-fencing - of retail and investment banking activities, legally, financially and operationally.
Part of their motivation is to stop some of the riskier parts of investment banking, such as proprietary trading, infecting the indispensible parts, such as deposit-taking and loan-making. The crisis has provided ample evidence of the costs of such cross-contamination, with losses on risky trading portfolios imperilling bank depositors and borrowers.
But at least as important is what such a separation might do ahead of crisis. Ahead of this time’s crisis, financial and human resources were diverted away from retail banking services and non-bank activities towards investment banking. At the same time, the culture and practices of investment banking infiltrated retail banking - a sales culture which culminated in harmful cross-selling and unlawful mis-selling.
If they are successful, these structural reform efforts will reverse this pattern. They will seek a separation, not just legally, financially and operationally, but culturally too between the very distinctive sub-cultures of transactional investment banking and relationship retail banking. That cultural separation ought to be the acid test of the success of these structural reform proposals.
There are those who doubt whether a ring-fence is sufficient to achieve that cultural separation in banking - can two separate sub-cultures really operate underneath a single roof? Time will tell. If it is not possible, then full separation would be the logical next step. Alternatively, banks themselves might of course voluntarily choose to divest and separate, as some are already doing.Why undertake these complicated structural reforms which may or may not work when simply requiring the banks to provide ultra transparency produces the desired result?
With ultra transparency, you change the culture and risk taking by the banks in a fundamental way.
Second, capital. Much greater levels of protection are being put in place for banks generally and for big banks in particular. ...
Regulation of this type might sound rather arid and technical. Welcome to my world. But it is also important. Higher financial buffers are not about protecting the banks – just like other firms, they can and should fail.They are there to protect the customers of banks, reducing the chances of them suffering panic or loss. And they are there to protect taxpayers too, reducing the chances of them footing the bill.....In that world it is well known that bank capital ratios are meaningless. As the OECD pointed out, the numerator, bank capital, is an easily manipulated accounting construct and the denominator, assets, whether on an as reported basis or a risk-weight adjusted basis are also easily manipulated.
It is intellectually dishonest to suggest that something as easily and highly manipulated as bank capital ratios have any role to play in a financial reformation.
If investors invested based on reported bank capital ratios, they would have lost a considerable amount of money investing in banks like Dexia which reported one of the highest bank capital ratios in Europe just prior to its nationalization.
Under the FDR Framework, it is the responsibility of the investors to independently assess the risk of each bank and to determine how much, if any, exposure they want to a bank based on their assessment of its risk and their capacity to absorb losses based on this risk.
Bank examiners demonstrate they understand the responsibility of investors (which they effectively are as they seek to protect the taxpayer from losses on the deposit guarantee).
Bank examiners do not rely on bank capital ratios, but rather look at 'capital adequacy'. Where capital adequacy attempts to answer the question of does the bank have enough capital to absorb the losses that can be expected given the risk of its exposures.
The fact that many economists strongly endorse a meaningless capital ratio does not mean that investors who put real money at risk or bank examiners who look after the taxpayers' exposure should rely on this meaningless ratio.
Again, this is why we need ultra transparency.
Third, compensation. There is a deeply-rooted problem of short-termism in modern capital markets, with too great a focus on near-term versus longer-term, on spending over saving, on twisting rather than sticking....Under the FDR Framework, regulators have absolutely no role in determining compensation. While you and I might not like banker compensation packages, it is not up to us to mettle in the design of these packages. Rather, we should focus on making sure that the bankers 'earn' their compensation.
With ultra transparency, the bankers who can deliver better earnings with lower risk deserve to be compensated better and they will be.
With ultra transparency, bankers who rely on more risk to generate their compensation will discover that their cost of funds increases and ends any benefit from increased risk taking.
Fourth, credit. The rising tide of inequality either side of the crisis was given impetus by first the boom and then the bust in credit and asset prices. We must in future do a much better job of moderating those credit booms and busts, to prevent them acting like a regressive tax on the poorest in society.
That collateral damage is all too evident today in the chronically low levels of credit being extended on the high street – to first-time buyers wanting to put their foot on the first rung of the housing ladder, to business start-ups seeking to invest in assets, human and physical. Lending to UK households and companies has been contracting for 4 years and counting.
In preventing a repetition, a first step is to recognise that taming the booms and busts in credit is a key public policy responsibility. Step two is charging someone with this task. And step three is getting on and doing just that.
In the UK, we are already three steps along this road, with the introduction of a Financial Policy Committee (or FPC) housed at the Bank of England from last year. Its remit is to keep the system safe and sound while supporting lending and growth.
Right now, the FPC is playing its part in trying to cushion the effects of the credit squeeze I mentioned, by freeing up banks’ capital and liquidity reserves to enable loans to be made to companies and households.
If these sound like small steps for mankind, then they are giant ones for regulators. This is the first time in the Bank’s 318-year history that it has attempted such “macro-prudential” regulation. Of course, it is impossible for the FPC or anyone else to eliminate mini-booms and mini-busts in credit. But the FPC can legitimately aim to head-off the maxi-booms, such as the pre-crisis one, and the maxi-busts, the like of which we are currently experiencing....What pure b***s***.
Isn't this exactly the role of Bank of England's monetary policy? (as I recall from my time working at the Fed, the central bank is suppose to take away the punch bowl just as the party gets going!)
Everyone knows that in the run-up to our current financial crisis, despite being charged with the task, the Bank of England did not take away the punch bowl.
There is zero reason to believe that the Financial Policy Committee will be more successful than the Monetary Policy Committee.
Fifth, we really must do a much better job of promoting competition in financial services. The most shocking statistic is that, up until 2010, no new bank had been set up in this country for a century. ...
There is already some encouraging evidence of new entrants to the banking market. In weak moments, I think that we might even be on the cusp of a technological revolution in banking. Certainly, some new firms are bringing new technologies to banking – for example, through mobile payments. Others are mobilising pools of non-bank funds to finance lending directly – peer-to-peer lending, crowd-funding, invoice-financing. Others still are demonstrating that a clear focus on retail banking services, delivered locally by forging long-term relationships, can be a winning strategy.
For example, take Handelsbanken. ...Their business model is fascinating, Quaker-even, in its orientation. They offer only basic banking services, mortgages and small business loans, to people in a tight, locally-defined catchment area. All credit decisions are taken locally by people, not centrally by a computer. No bonuses are paid and no-one has a sales-target. When the whole firm out-performs, a contribution is made to a pooled fund which is invested on employees’ behalf.
The fruits of success are distributed equally and gratification is deferred.
For banking, this is back to the future....Requiring the banks to provide ultra transparency is also an example of back to the future for banking.
Back before the advent of deposit insurance in the 1930s, the sign of a bank that could stand on its own two feet was a bank that provided ultra transparency and allowed everyone to see all of its exposures.