Swallowing the bankers' line

Earlier this month, Robert Jenkins, former external member of the Bank of England's financial policy committee, observed:

I fear that the banks have bamboozled government into believing that society must choose between safety and growth, between safer banks and bank shareholder value, and between a safer financial framework and a competitive City of London. These are all false choices.

Please re-read the highlighted text and ask the question of how could this have come to pass.

In his Project Syndicate commentary, Professor Simon Johnson offers a series of potential explanations for how banks have bamboozled government.

There are three possible explanations for what has gone wrong. 

One is that financial reform is inherently complicated. But, though many technical details need to be fleshed out, some of the world’s smartest people work in the relevant regulatory agencies. They are more than capable of writing and enforcing rules – that is, when this is what they are really asked to do. 

Your humble blogger wonders when the regulators within the SEC decided that they were not really being asked to ensure transparency in the financial system?

Regular readers know the SEC was ground zero for the financial crisis and it was the failure of the SEC to ensure transparency that created the conditions for the financial crisis.  Specifically, the SEC allowed opacity for both banks and structured finance securities.

For banks to be transparent, they must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This was the law in the UK since the 1870s and the standard in the US in the 1930s when the SEC was created.  Clearly, by the start of the financial crisis in 2007, this was no longer true.

For structured finance securities to be transparent, they must disclose on an observable event based basis.  Every observable event like a payment or delinquency involving the underlying assets must be reported to all market participants before the beginning of the next business day.  Clearly by the start of the financial crisis in 2007, this was not true as opaque, toxic sub-prime RMBS deals report on a once per month basis.

The second explanation focuses on conflict among agencies with overlapping jurisdictions, both within and across countries. Again, there is an element of truth to this; but we have also seen a great deal of coordination even on the most complex topics – such as how much equity big banks should have, or how the potential failure of such a firm should be handled. 

Another source of conflict is the regulatory race to the bottom.

That leaves the final explanation: those in charge of financial reform really did not want to make rapid progress.  

In both the US and Europe, government leaders are gripped by one overriding fear: that their economies will slip back into recession – or worse.  

The big banks play on this fear, arguing that financial reform will cause them to become unprofitable and make them unable to lend, or that there will be some other dire unintended consequence. There has been a veritable avalanche of lobbying on this point, which has resulted in top officials moving slowly, for fear of damaging the economy.

Professor Johnson has nicely explained that fear is why the banks were successful in bamboozling government leaders.

But did the government leaders actually have anything to fear?  After all, the first response to the financial crisis was to put the banking system on life support.

Regular readers know that the answer has always been no  There was nothing to fear, but fear itself.

Our financial system was designed to survive even the failure of the SEC to ensure transparency.  Our financial system was designed to survive a massive credit bubble with the creation of excess debt that was well beyond the borrowers' capacity to repay.

Our financial system was designed to survive because it has a safety valve to release its excesses while protecting the real economy.

This safety valve is the ability of banks to absorb upfront the losses on the excess debt in the financial system and continue to operate and service the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners when they have low or negative book capital levels.

Of course, because government leaders swallowed the bankers' line, we have never used the safety valve.

Instead, we have protected bank book capital levels and banker bonuses while at the same time burdening the real economy with servicing the excess debt.  The result has been economic stagnation, an unwinding of the social contract and an increase in inequality.