Reform of banking needs to go much further

In his Financial Times column, Martin Wolf lays out a compelling case for why banking reform needs to go much further than what is currently being proposed.

An industry that has taken the public for a ride must be made to change its ways. 

The financial crisis has imposed economic and fiscal costs upon the British economy and public finances that rival those of a world war.

This is also true in the EU and US.

This brutal fact must inform the response. 

It is why it has to be radical. Business as usual will not do because that could lead to national ruin. 

No industry can be allowed to operate in such a way. 

As Sir Mervyn King, outgoing Bank of England governor, noted this week: “It is not in our national interest to have banks that are too big to fail, too big to jail, or simply too big.”

Please re-read the highlighted text as Mr. Wolf has nicely summarized what the problem is with the global, financial institutions.

It is quite likely that the crisis will cost the UK a sixth of gross domestic product, in perpetuity. 

How is this disaster possible? 

The answer is that we have entrusted a private industry with the provision of three public or near public goods: the supply of money; the payments system; and the supply of credit. 

But credit is risky, while money and payment have to be safe. 

For this reason governments have provided ever stronger safety nets. 

Profit-seeking bankers have responded by making their institutions increasingly fragile: the desire to make banks safer allows bankers to take more risk.

Unfortunately, Mr. Wolf stops before looking at the role of regulators in setting and enforcing the rules so that banks do not take on excessive risk.

Regular readers know that your humble blogger has been saying that banks must be subjected to market discipline if they are going to restrain their risk taking.  The only way to subject them to market discipline is by requiring them to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is the regulators responsibility under the FDR Framework to ensure that banks provide this level of disclosure.  Unfortunately, regulators have not done so and as the Bank of England's Andrew Haldane says, banks are "black boxes"where the bankers can take on excess amounts of risk and not be subject to market discipline.

It is only against this background that we can assess the proposals of the report by the Parliamentary Commission on Banking Standards, out this week. It is a depressing, but impressively radical, document. It lays bare the malfeasance and incompetence that characterised UK banking before the crisis.

Malfeasance and incompetence that also characterized EU and US banking before the crisis.

The report is wide-ranging. It has much to say, for example, on competition. 

But soundness of the system is the heart of the matter. 

Unbridled competition over who can run their bank more irresponsibly offers only a transitory benefit to customers. 

Sound competition is possible if, and only if, the risks are fully internalised by decision makers. They were not, as the report shows.

The only way risks are fully internalized by decision makers is if market participants have the data they need so they can assess the risk of each bank and link its costs of funds to its level of risk.

The only way market participants can have the necessary data to do this assessment is if banks provide ultra transparency.

Bankers who ran their institutions into the ground left with great wealth, leaving the public, in general, and taxpayers, in particular, to pick up the pieces. 

So what is to be done? The answer, in essence, is to focus on structure and incentives. 

The beauty of transparency is that it focuses on both structure and incentives.

With transparency, bankers will have to make their money by providing the services that society needs and not by betting with taxpayer money.