The weakest links
Jan 21st 2010
From The Economist print edition
New capital and liquidity rules will make the average bank safer. But what about the outliers?
IT IS bonus season again. Bankers get bashed and governments invent ways to tax them, most recently Barack Obama’s plan to charge banks an annual insurance fee. Amid all the rancour, some say it is important to regain a sense of perspective. Banks have been bailed out throughout history. People hate it, but they would hate the devastation that a collapse would bring even more. Besides, finance’s wild-west era is over. The Basel club of regulators is tightening its rules and there is talk of new curbs on proprietary trading.
Problem solved, then? Unfortunately not. The pact between society and banks has changed dramatically over the years. Once, banks got liquidity support from a lender of last resort. In the 20th century they got state-backed deposit-guarantee schemes. And now they enjoy an implicit blanket guarantee of all their liabilities, allowing them to borrow cheaply. All this has let the industry operate with smaller safety buffers than in the past, and balloon in size. Relative to the size of the economy, Britain’s banks are ten times larger than in 1970.
That blanket guarantee is unfair. Some of the subsidy is passed on to banks’ customers, but much goes to their staff. It may be unsustainable: the assets of America’s banks are now as big as its GDP, taxpayers in most rich countries are underwriting systems several times larger than their economies, and it is unclear whether tiny Iceland will honour its commitments. The guarantee is also dangerous. As any capitalist knows, firms with subsidised funding and no risk of failure usually misallocate capital and can be dysfunctional, as the mortgage agencies Fannie Mae and Freddie Mac demonstrate.
The Basel club is making a decent fist of rewriting its rules on capital and liquidity, forcing the banks to operate with larger safety buffers. But regulators must be brutally honest about what these reforms will achieve. The banking system is only as strong as its weakest links, and even the new, bigger buffers would not have been enough to prevent the worst blow-ups of the past two years. That is understandable: banks’ capital would need to double to deal with the risk that they might be the next Merrill Lynch or UBS. Passing the cost of that on to customers could hurt the economy.
If the state is thus doomed to bail out tomorrow’s basket cases, it should charge for the guarantee banks get. One option, which Mr Obama has proposed and which this newspaper has supported, is a “liability levy” on banks’ debt to recoup the subsidy they get from artificially low borrowing costs. Banks already pay a similar levy on their insured deposits; a liability levy would hit investment banks, too. It should help to rein in bonuses somewhat, and could fund a bail-out kitty. Such a levy addresses some of the problems that arise from the blanket guarantee, but in the long run it would be best to withdraw it. That will not be easy. Banks’ creditors must suffer losses if taxpayers are to avoid bail-outs. Yet if all creditors and counterparties fear loss, they will run from a weak bank, creating a self-fulfilling prophecy. What is needed is a way to create the halfway house of partial bankruptcy.
Building a half-way house
One option is for banks to issue so-called “Coco” bonds that convert into equity if capital gets too low, although no one really knows how such instruments would behave in a crisis. Another is to give a resolution agency powers to deal with bad banks. This agency cannot be just a glorified contingency planner, but it cannot be a despot either, otherwise terrified creditors and counterparties will run if intervention seems likely. It needs absolute authority to impose losses, but over only part of a bank’s balance-sheet. This would require banks to ring-fence the bits worth saving (such as retail deposits), or force them to carry debt that gets a mandatory haircut if the state has to step in. All big banks would have an implicit guarantee, but it would not cover their entire balance-sheets.
It is all too easy to pretend that new capital and liquidity buffers will be enough to prevent the need for future bail-outs, but it is unlikely to be the case. Devising a way to impose controlled losses on failed banks’ creditors, and convincing markets that it really will be used next time there is a crisis, will be difficult. But anyone with a sense of perspective can only conclude that public backing of finance has reached unacceptable levels. Solving that problem must be regulators’ priority.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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