Surprise, banks are still a danger to the real economy

In his Financial Times column, Chris Giles looks at the reasons that banks are still a danger to the real economy.

Unfortunately, he leaves off his list the number one reason banks are a danger to the real economy: politicians and financial regulators who do not use a modern banking system as it is designed to protect the real economy by requiring banks to recognize upfront the losses on the excess debt in the financial system.

This failure to use banks as they are designed shifts the burden of the financial crisis from the banks onto the real economy.

This burden hurts the real economy in several ways.

For example, it diverts capital needed for reinvestment, growth and supporting the social contract to debt service payments on the excess debt.

For example, it makes it virtually impossible to get a loan as valuing the collateral being offered becomes extremely difficult.  This is particularly true of real estate collateral where the price of real estate is being artificially propped up through banks not foreclosing, banks engaging in 'extend and pretend' and turning non-performing loans into 'zombie loans', and central banks pursuing zero interest rate policies.

When the authorities intervene in banking, their aim is to protect the economy from the banks rather than the banks from the economy.

Please note that authorities intervening in banking was done based on advice from the bankers.

The banking system is designed so that authorities do not need to intervene, particularly to protect bank book capital levels and banker bonuses, as they did and still do.

This turn of phrase, borrowed from Sir Mervyn King, the outgoing Bank of England governor, should be the yardstick for progress. 

On the morning after the annual Mansion House speeches by the BoE governor and the chancellor, the question is whether George Osborne is correct to say that the UK has reached a turning point from “rescue to recovery”? Is the economy now protected from banks?... 

The simple answer is No. 

The move from rescue to recovery is a question of degree and there is quite some way still to go. Sir Mervyn talked about “the work of a generation”....

Well Sir Mervyn should talk about the "work of a generation" as the EU, UK and US borrowed their policy response from Japan which had a similar banking crisis and is still trying to work its way out of that crisis a generation later.

Much progress has nevertheless been made since 2007. 

The crisis at Co-operative Bank demonstrates that parts of the new regulatory mechanisms are working in the way ultimately intended. ....That new arm of the BoE stood its ground and insisted the Co-op plug a £1.5bn hole in its capital buffers. With the authorities demanding action and no taxpayer money on the table, the wider Co-op group has been forced to inject money from other parts of the business and extract a significant, but still to be determined, contribution from bondholders. 

There was no knock-on distress to other banks’ funding costs or lending. This was banking recovery in action, a regulatory intervention much preferable to the resolution of a dying bank or a taxpayer bailout.

This is the way that a modern banking system has been designed to operate since the 1930s.  This is simply an example of the regulators using the bank as it was designed.

But what is true for the Co-op or for other small financial entities still would not apply to the big boys. If RBS, Lloyds, Barclays, HSBC, Nationwide or Santander UK got into difficulties, the authorities could not stand back. 

Authorities could stand back.  Authorities will not stand back.  After all, they have to consider their post political or regulatory careers.

Nor will we know, ultimately, how healthy Britain’s banks are until monetary policy returns to something approaching normality. The eventual return to interest rates near 4 or 5 per cent contains many hidden dangers for banks if their customers cannot cope with higher borrowing costs. 

Before a new world of normality can be achieved, action is still needed on many fronts to make banks and bankers a more normal part of the British economy.

There is no reason to ever expect monetary policy to escape the ZIRP/QE trap.  These policies are designed to artificially inflate asset prices and hope that the wealth effect will spur economic growth to support the inflated prices.

The problem is that the wealth effect has been shown to be virtually non-existent.

Four “Cs” are especially relevant in removing the special tag from banking and bankers. 

As the parliamentary commission makes clear, the first is the conduct of the industry. Perverse incentives with enormous rewards for success and insufficient sanction for failure must be addressed, especially when the distinction between both depends so much on luck. Deferred bonuses, clawbacks and the mere hint of criminal penalties will help, but can be successful only if banks and bankers embrace a new culture. Success is far from guaranteed....

As regular readers know, conduct of the industry is easily addressed by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is well known that sunlight is the best disinfectant of bad banker behavior. Effectively, sunlight introduces a new culture into banking based on providing services society needs rather than betting with taxpayer money.

Third comes the more difficult area of capital. While banks are far better capitalised than in 2007 and in the long run the BoE is right to argue that higher capital levels do not impede lending, the transition is difficult and gives banks the incentive to reduce lending in the process of becoming safer.

Capital is another area that is easily handled by ultra transparency.

First, with this level of disclosure, banks are subject to market discipline to recognize all the losses currently hidden on and off their balance sheets.

Second, with this level of disclosure, market discipline is exerted on banks to rebuild their book capital levels while restraining their risk taking.  In the 1930s when ultra transparency was seen as the sign of a bank that could stand on its own two feet, banks carried much higher levels of book capital.