Regulating banks
The devil's punchbowl
Jul 9th 2009
From The Economist print edition
You thought that the party was over. Think again
Illustration by David Simonds
A NEW hiring frenzy in the City, with bonuses guaranteed for “only” the first year; investment-banking results for the second quarter likely to top those of the first; an innovative securitisation by Barclays to get bank loans off its balance sheet. The term “business as usual” normally delights tradesmen and their customers. Applied to the banks that plunged Britain into economic crisis, it strikes fear to the heart.
Promised reforms to bank regulation, meant to curb the excess before it starts all over again, are in limbo. On July 8th Alistair Darling, the chancellor of the exchequer, unveiled plans to make banks hold progressively more capital, the bigger and more complex they are. Banks will be required, in effect, to add capital if they pose special risks to the system, including higher capital charges if they pay bonuses that encourage short-term risk-taking.
This all sounds plausible. But Mr Darling failed to explain how those varying capital requirements will be assessed and applied. In fact their calibration will depend not on Britain alone but also on work being done in Brussels for the European Council (a draft law is expected in October). And rules to increase the money banks must hold for liquidity are coming from the Basel Committee, a club of rich-country bank supervisors.
He also failed to change the outfit in charge of bank supervision. The much criticised “tripartite arrangements”, designed to help the Treasury, the Bank of England and the Financial Services Authority (FSA) act as one in a crisis, are hardly touched. The trio failed in its first big test, the collapse of Northern Rock in 2007, prompting calls for authority over banks to be concentrated in the Bank of England, as it was before Labour took power in 1997. Instead, Mr Darling wants the FSA to impose the varying capital charges; the Bank of England is to assess the systemic risk on which the charges will be based but will not have the power to enforce them. Overseeing it all will be a Council for Financial Stability, chaired by the chancellor himself.
Mr Darling’s long-awaited white paper sets out a blueprint of sorts for how the current regulatory system might be adapted to more perilous times. It ducks the big questions, however. In particular, a lively debate over whether risky “casino” investment banking should be split from “utility” commercial and retail banking, guaranteed by the taxpayer, has been cut short. The hope seems to be that, as their activities demand more capital, riskier investment banking will be reduced or spun out of banking groups. More pressure to shrink may come from an insistence that banks demonstrate regularly how they would wind down their affairs in an orderly manner in the event of failure.
The European Union (EU) may also have a stick to wield, though it is not yet clear how big. On June 30th Neelie Kroes, the EU competition commissioner, declared that Royal Bank of Scotland (RBS), one of the two large banks the British government rescued and took a stake in, was too big, too complex and “highly dangerous to the European single market”. The EU has the power to demand the restructuring of a company that has received state aid. It has already done so with German banks.
Yet there is little sign that the government itself has the appetite or the will to confront such big banks head on, despite their huge size relative to GDP (see chart). UK Financial Investments (UKFI), the agency that runs the government’s stakes in rescued banks, seems interested only in preparing to sell them, not in getting the banks to serve the economy better. Moreover, its acquiescence in a £9.6m remuneration package for Stephen Hester, the chief executive of RBS, tied to the bank’s share price hardly discourages the resurgence of the old bonus culture. Exhortations by Paul Myners, the Treasury minister who oversees UKFI, to end short-term share-price targets ring hollow.
Indeed, the pay culture that rewards bank bosses for short-term risk-taking has barely been touched. Bonus pools, which in some firms scoop up as much as 50% of trading revenues, are a hangover from the days of private finance houses, when partners shared losses as well as gains.
A draft review of corporate governance in banks is due on July 16th. It is chaired by Sir David Walker, a senior adviser to Morgan Stanley, an investment bank.
Understandably, the government is scared to risk further erosion of London’s position as a global financial centre. The earnings from financial services in a good year add over £25 billion to government revenues, and the financial sector employs over 1m people across the country. Against that is the loss in economic output from a full-scale financial crisis, which averages around 20% of GDP, according to an IMF working paper.
Adair Turner, the chairman of the FSA, expects no certainty on financial regulation until after the general election, to be held by next June. The opposition Conservatives, who are likely to form the next government, will produce their own white paper later this month. Apart from a promise by George Osborne, the shadow chancellor, to rip up the tripartite structure and give prudential supervision to the Bank of England, not much is likely to be proposed that would affect bank size, complexity or bonuses. Only Vince Cable, financial spokesman for the Liberal Democrats, argues for splitting up banks and making them lend more.
Stirring in the underbrush, however, is the Bank of England, which is beginning to provide the kind of analytical leadership that might have blunted the crisis had it come earlier. An analysis of the crunch by Andrew Haldane, the director for financial stability, has been described as “brilliant, but two years late”.
More recently Paul Tucker, a deputy governor of the Bank of England, has spoken of a new “social contract” between banks and society, which would impose more realistic costs on banks for the taxpayer’s implicit guarantee. Why were those costs not priced in or even considered before? And, given the government’s fear of upsetting the City, are they likely to be priced in now?
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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