Saturday, February 9, 2013

"Unpunished and unreformed, the bankers have got away with it"

In his Guardian column, Phillip Inman notes that little has changed in the banking industry that brought on the financial crisis.

Of course, this was the explicit goal of the policy of financial failure containment and its corollary, the Geithner Doctrine (nothing must be done that will hurt the profit or reputation of any bank that is big and/or well-connected).

Unfortunately, much has changed outside the banking industry.  And all of this change has been for the worse.

The list of changes includes, but is not limited to:

  • governments that are pursuing austerity policies and re-writing the social contract so that they can repay the debt taken on as a result of the financial crisis;
  • savers that are having to cut back on current consumption so as to offset the loss of earnings on their savings caused by central banks pursuing zero interest rate and quantitative easing policies; and
  • companies that are seeing their profitability hurt as competitors who should have gone out of business because they have too much debt are allowed to continue as a result of regulatory forbearance that lets banks turn these bad debts in to 'zombie loans'.

Regular readers know that your humble blogger has been saying since the beginning of the financial crisis that there is an alternative that ends the financial crisis and brings change to the banking industry without the negative changes to society and the real economy.

This alternative is the policy of financial failure prevention.  This policy is the foundation of the global financial system and is summarized by the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, investors have an incentive to use the information that is disclosed to independently assess the risk of any investment to make a fully informed investment decision as the investors are responsible for all losses on their investments.

The one exception where investors are not responsible for losses on their investment is bank deposits.

The FDR Administration recognized that it was necessary to have a banking system that functioned at all times to support the real economy.  The solution for achieving this was the combination of deposit insurance and access to central bank funding.

As I have repeatedly said, the combination of deposit insurance and access to central bank funding allows a bank to continue operating even when it has low or negative book capital levels.  A bank can do so because a) the taxpayers effectively become the bank's silent equity partners and b) anyone looking to withdraw their deposits can do so as the central bank provides the necessary liquidity.

Please note that even though depositors are protected this does not mean that investors in bank stock or unsecured debt are suppose to be protected.

In our current financial crisis, an argument could be made that these investors had to be protected as a result of the performance of the financial regulators.

First, the financial regulators did not fulfill their responsibility under the FDR Framework of ensuring that market participants had access to all the useful, relevant information about each bank in an appropriate, timely manner.  As the Bank of England's Andrew Haldane said, banks are 'black boxes'.

As a result, market participants could not independently assess the risk.

Second, the financial regulators made public announcements about both the risk and solvency of the banks both before and during the financial crisis (who can forget Tim Geithner's stress tests).

As a result of the regulators' public announcements, the financial regulators created a moral obligation to bailout the investors who relied on the regulators' risk assessment to make an investment (by the way,  FDR made the point very clearly that the government should not be in the business of offering an investment opinion because it would create this moral obligation to bailout the investors).

Finally by designing both the financial system and the banking system the way the FDR Administration did, a safety valve was created should the global financial system ever encounter a bank solvency led financial crisis.

The banks are the safety valve between the excess debt in the financial system and the real economy.  Because of their unique ability to operate with low or negative book capital levels, banks can absorb all the losses on the excess debt in the financial system and protect the real economy.

Of course, many changes occur in a bank that has low or negative book capital levels.  These changes include that cash compensation is dramatically lower until such time as the bank has retained sufficient earnings to rebuild its book capital levels.

Bottom line:  by pursuing a policy of financial failure containment and its corollary, the Geithner Doctrine, global policy makers didn't use the financial system as it was designed and instead of having the banks protect the real economy from the excess debt in the financial system, the policy makers but the burden of the excess debt in the financial system on the real economy.

Fortunately, policy makers could abandon the policy of financial failure containment and its corollary, the Geithner Doctrine, and use the financial system as it was designed.  This would lift the burden of the excess debt from the real economy and put the burden of the excess debt on the banks and banker bonuses.

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