David Shirreff – Fifteen wasted years of attempted bank reform

Regulators have squandered the fifteen years since the last financial crisis, and failed to bring real change to the banking system – as the past couple of weeks have shown.

David Shirreff is a financial writer and contributor to Brave New Europe

When panic struck Silicon Valley Bank (SVB) on March 9th, then banks in other financial centres, regulators had to reach for the same old toolkit to steady the ship: central banks lent their balance sheets to prop up diminishing confidence in a number of banks – all at a cost or risk to the taxpayer.

That was not supposed to happen ever again. Big banks judged too-big-to-fail were supposed to carry enough capital to support their own solvency or dissolution. Small banks below the too-big-to-fail threshold were supposed to rely on the backstop of statutory deposit insurance to prevent panic among the bulk of their small depositors.

The near-collapse of a small bank, SVB, and the implosion of a big bank, Credit Suisse, were arrested only by central bank intervention. The Federal Reserve, the Bank of England, and the Swiss National Bank used their muscle to prevent panic selling and steady the wider financial system. Later, German Chancellor Olaf Scholz made a public attempt to stem a slide in Deutsche Bank shares.

This sad failure by regulators to create a robust banking system is due to one thing: their refusal to recognise that much of what we call banking should be treated as a utility. People need somewhere safe to keep their cash and make payments. That depository and payment system can be a bank or an electronic wallet. A bank protected by statutory deposit insurance is safer.

Regulators have spent the last decade footling around with attempts to protect complex banks from sudden failure, not by re-ordering their structure, but simply by adding rules and demanding more capital.

A case in point is the creation of a new class of tier 1 capital, called Additional Tier 1 bonds (AT1s) or Contingent Capital. When it came to the crunch in the case of Credit Suisse, the Swiss regulators made one choice (reducing the bank’s AT1s to zero, while retaining some value in the ordinary shares) while the consensus among European regulators was that the ordinary shares should have been wiped out first. That has sowed confusion in the market for an ill-conceived new class of subordinated debt which needn’t have existed in the first place. What’s wrong with ordinary equity?  

The most important step that regulators could have taken in the past fifteen years – to separate speculative, risky trading from the utility function, so-called ring-fencing – has not been properly implemented and is now under threat of reversal. It has become a hotly contested issue among laisser-faire politicians and bankers themselves. Last December UK Chancellor of the Exchequer Jeremy Hunt unveiled a package of de-regulation proposals which would loosen many of the ring-fencing measures already in place.

The reality is that banks, even small ones, are inherently unstable and will occasionally need rescuing. A simple bank takes short-term deposits and makes loans, usually of longer maturity. If all its depositors demand cash on the same day the bank will go bust. To stop that happening the bank’s deposits, up to a certain size, are insured by a state-backed insurance scheme. Public awareness of that insurance should in theory be enough to prevent a run on the bank. But experience has shown that it isn’t enough. To stop panic, in most recent cases, the national government has had to guarantee all deposits, not just the smaller ones.

Governments do not like to pre-announce such a policy, for fear of encouraging banks to lend recklessly. That is the crux of the problem. A system of banks whose simple deposits are perfectly safe, is desirable, but not achievable.

There have been proposals to overcome this problem by establishing banks whose deposits are 100% guaranteed by the state – so called non-fractional reserve banking.

However, a central bank, and the government behind it, charged with guaranteeing those deposits would inevitably become involved in deciding how that money is put to use. Allocation of loans would become a centrally controlled process – anathema to all but the most ardent socialist.

How can that be avoided? All banking systems are a fudge. But those banks that are close to a community tend to do better on credit decisions (unless they are corrupt) than those that are centralised. German co-operative and savings banks have long been cited as models. Their record is not stainless, but their system of joint and several liability across the savings bank or co-operative bank membership has generally worked well.

The Anglo-Saxon model has drifted far away from that simple landscape. In its race to compete with other financial centres, especially since Brexit, the UK has been anxious to maintain its reputation as one of the most liberal regimes in the world. The latest fracas, whose focus was mostly beyond British shores, may have encouraged UK regulators to think that they have their big banks and wider financial institutions under control. But they should be reminded that, since 2008, not much has changed in terms of the vulnerability of large, complex financial institutions to a crisis of confidence.

In 2016 in a book called Break Up The Banks! – which clearly went unheeded by leading regulators – I recommended the full nationalisation of Royal Bank of Scotland and Lloyds Banking Group which were both then still largely in UK government ownership. I called for a clear separation of investment banking from commercial and retail banking, with investment banking being spun off into a partnership, giving the partners unlimited liability. Meanwhile the retail and commercial banking arms would be strongly capitalised. Incentive packages for executives and staff would be severely limited. I wanted a change in the culture of the City, so much modelled on the culture of Wall Street, but without having skin in the game.

A week ago, department store owner John Lewis, a mutual company, cut its partners’ (employees’) bonuses to zero, because it made an annual loss, while HSBC, which had just bought the UK subsidiary of Silicon Valley Bank for £1, announced that it would honour staff bonuses promised at SVB despite the rescue. Quite a cultural contrast.

Indeed culture is the unfixed problem that financial regulators simply have not addressed or have been too weak-minded about. Turning large chunks of the financial sector into 100% secure – and perhaps publicly-owned – utilities would be a good goal to have – and would willy-nilly bring a cultural change.

“Break Up The Banks!” by David Shirreff, published by Melville House (ISBN: 9781612195025), Price: $13.95.  An earlier version of the book “Don’t Start From Here” is reviewed HERE

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