Too Big to Fail? Then Break It Up

Daily Telegraph January 12, 2010

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By Jeremy Warner Published: 10:51PM GMT 11 Jan 2010

Comments 8 | Comment on this article

In the West End the other day, I was witness to the following bizarre invective from a man as he tore a parking ticket from the windscreen of his vehicle. “Bloody bankers”, he cursed, as if bankers can these days be blamed for almost any misfortune, however trivial.

The economic crisis may be abating, but public fury with the banks shows few signs of doing the same. Small wonder. Summing up the prevailing perception, the chairman of “The Financial Crisis Inquiry Commission” in the US, Phil Angelides, likens events to an earthquake where the only buildings left standing when the quake has passed are those that were at its very epicentre.

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Without trillions of dollars of public support, they too would have collapsed as surely as the rest of the economy, yet the bankers are behaving as if nothing of significance happened at all, with asset markets once more skipping along with apparent abandon, and, despite the efforts of the British government and others to deter them, near record bonuses about to be declared.

With banking chiefs again being called to public account on both sides of the Atlantic this week – in Britain before the Treasury Select Committee and in the US in front of Mr Angelides’ commission – the cry is going up afresh: “Something must be done”.

But what? Policy-makers seem as far away from meaningful answers as ever. The reform agenda, which is trundling along towards some kind of a solution based on higher capital and liquidity controls, seems slow, inadequate and opaque.

To see what I mean try taking a look at the Basel Committee’s latest proposals for strengthening the banking system, many of which are expressed in algebra. How’s anyone outside banking and regulation expected to understand that?

Policy-makers want to ensure that never again can taxpayers be held to ransom on the monumental scale that’s just occurred, but at the same time they want the banking system to fun

By Jeremy Warner Published: 10:51PM GMT 11 Jan 2010

Comments 8 | Comment on this article

Policy-makers want to ensure that never again can taxpayers be held to ransom on the monumental scale that’s just occurred, but at the same time they want the banking system to function as before in funding growth, and therefore daren’t do anything too radical.

Rightly or wrongly, bankers have succeeded in persuading them that all that needs to be done is to make the system a little safer. The approach falls short on a number of levels.

First, it doesn’t provide cast iron protection against the “too big to fail” (TBTF) problem, where with very large failures governments are forced to put their own solvency in jeopardy in order to stop the payments system collapsing.

Second, it leaves unaddressed the issue of moral hazard, effectively allowing banks to game the system in the knowledge that if things go wrong, there’s always the taxpayer to pick up the tab. And thirdly, it looks set to accentuate the problem of contracting and more expensive credit to households and small business. Yet the only policy-maker of international significance who seems to share this view is Mervyn King, Governor of the Bank of England.

As he put it in a speech last year: “The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the ‘too important to fail’ question. The belief that appropriate regulation can ensure that speculative activities do not result in failures is delusion.”

Delusion it may be, but the international consensus has fallen hook, line and sinker for the argument that it is impossible to run a sophisticated and prosperous economy without these goliaths of finance in our midst.

A masterful analysis of the issues is set out in a new report from Barclays Capital, “European Banks: Too Big to Fail”. Though perhaps understandably, given where the report came from, the authors reach the opposite conclusion to me.

Rewind to 1990, and there was no such thing as a TBTF bank. Of the top 25 banks in the world, none possessed a balance sheet of more than 25pc of their host country’s GDP, bar UBS of Switzerland.

Yet by 2007, quite a lot of them had hugely outgrown the ability of their host nations effectively to underwrite them, with balance sheet liabilities of well in excess of 100pc of GDP, and virtually all of them had engaged in massive balance sheet expansion.

None of this means that large banks are inherently less safe. Analysis by Barclays finds that, on the whole, large banks are less prone to go belly up than smaller ones. Yet, as we have discovered, the consequences when this once-in-a-blue moon event does take place are catastrophic. What might previously have been a relatively minor and localised financial crisis is turned overnight into a global and fiscal crisis of monumental proportions.

And in any case, as the Barclays analysis demonstrates, any attempt to make banks unambiguously too safe to fail through capital, leverage and liquidity controls would require so much more capital, or alternatively balance sheet reduction, that it would seriously compromise the whole purpose of the banking system in providing credit at an affordable price.

A complementary approach favoured by regulators in Europe and the US is to structure banks in a way that would allow orderly and controlled failure through so-called “living wills”. Yet it is easy to see why the likes of Michael Geoghegan, chief executive of HSBC, is so opposed to being required to prepare for the undertakers. By making cross-border capital and liquidity flows more difficult, living wills would enormously add to the local capital and liquidity needs of even the most conservatively run of multi-national banks.

Whatever. It is clear enough what the lessons of this crisis are. Some banks became too big, or systemically important, to be safe. To keep the bonuses flowing, they chose reckless balance sheet expansion over common sense. The banking system must not be allowed to outgrow itself in this way again.

If that means breaking the banks up, through structural separation of plain vanilla banking from risky casino banking, or simply making them smaller, so that they are made safe to fail, so be it. There is no rule that says smaller banks will make globalisation unravel, and therefore stunt economic growth.

Economies grew perfectly well before the arrival of these monsters from the deep, many of which are in any case far too large for managements and regulators adequately to control. The sooner their stranglehold on industry and business is broken, allowing alternative sources of finance to develop, the better it will be for the economy.

Unfortunately, it may require a further banking crisis yet for the policy-makers to see sense. Patching up the old system, however discredited it might be, is for the time being the easy option.

Comments: 8

How about adapting Gordon Brown's proposal to levy financial institutions by asking all countries to add 1% to the base corporate tax rate for companies earning more than £100 million profit, 2% on greater than £1 billion, 3% on profits greater than £10 billion etc. Companies would be encouraged by shareholders to break up huge entities. CEOs would not always be concerned with growth for growth's sake. Society would be levying a charge on the TBTF companies whether it be Citibank, Ford, BP, Tesco, Pfizer, etc. Breaking up companies might grant new entrants to the market a chance to compete against near monopolies. Companies might be encouraged to keep profits low in good years by investing in research/donating to charity.

allow the banks to be as big as they like - but only under the following conditions 1) upped capital reserves - these, and the ratio, to be strictly defined by the financial authorities 2) a general maximum leverage ratio; this based on the the banks´own capital reserves servicing such leverage - therefore variable the problem is solved kind regards

Mervyn King is a great man as demonstrated by his support for Aston Villa and his active encouragement of the increased participation of young people in cricket. Is there any other "policy-maker of international significance" that consistently demonstrates such levels of integrity and common sense. I am sure the answer is an emphatic no because they are too busy stuffing their extensible snouts into the trough.

I think this misses the point. If the man in the street thinks that his money is at risk then he will keep it under his bed which will render the entire banking system broken anyway. To my mind it's not that the banks are too big to fail, it's that they are too systemically important to the proper functioning of our current economic system.

If people were to trade at personal liability, as used to be more generally the case, that would address the moral hazard issue admirably.

I agree.

At last some common sense. The credit crunch was excelerated by two factors: fear of counterparty risk and the impact of mark to market accounting. Each are influenced by the psychological factors prevalent in the market. When Lehmans ceased it was a full month before the auction to determine what each lending institution exposure was to the collapse. A vacuum which incorporated many headless chickens. The support given to the banking system was inevitable given the current system. If the cash machines hade been turned off for more than a few days, it would have become a social order issue testing the police rather than a financial crisis. When the run on Northern Rock occured it was the UK Government's guarantee for depositors that brought stability. All banks benefited even the well capitalised, ordinary depositors recognised the state would ensure their savings are protected. However the credit crunch has identified their is a systemic risk in the current financial system. Fractional Reserve Banking only exists when depositors and other debtors accept their money will be repaid. The promise to repay needs to be accepted without any doubt. As a taxpayer I am angry that giving an implicit guarantee to bankers has encouraged excessive risks, rewarding mediocre performance in an increasingly restricted market with lavish bonuses. I will however be even more angry if politicans do not ensure that retail banking is separated from the risker bonus rich investment banking. I accept retail banking probably needs taxpayer support as a last resort,investment banking does not, bankers and shareholders should earn these bonuses. Re-examining Glass-Steagall that operated in the USA is a principle that will no doubt cost the UK financially. It is a price worth paying. Britain will have to make & export 'things' not just financial products. When the next banking crisis occurs I will not accept politicans and media excuses blaming solely the bankers. Bankers play by the rules and limits politicans set. Politicans are first and foremost elected to ensure the rule of law and order is maintained. Please do the job for which you where elected without delay.

"A bank to big too fail" is also a anti-monopolistic issue. Such bank can take far greater risk and unfairly undercut competitors who are not too big to fail. The question is: where have monopoly regulators been? They conspicuously failed in their duty. READ this brilliant piece: "Enforcing law is the best regulator" - http://gregpytel.blogspot.com/2009/07/enforcing-law-is-best-regulator.html