Banking: risk and reform
Thanks to Martin Wolf's timely op-ed in the Financial Times on Friday, I was alerted to a brilliant speech made by Robert Jenkins, an external member of the Financial Policy Committee of the Bank of England on 10 July 2012. I couldn't recommend it more highly as a reasoned case for banking reform with the figures to back up its arguments.
The subject of Jenkins' focus was banking regulation; specifically, whether there is too much of it and whether it is damaging for banks and the economy. In turn, he laid out the logic of holding more capital for riskier banking activities (a system of "risk-weighted assets") and the historical precedent, and new proposals, for reforming the capital that banks are required to hold.
The shock that he delivered to the Worshipful Company of Actuaries was that, in contrast to bankers' opposition to the 'over burdensome' regulatory requirements being introduced, banks are still only required to hold less than 1.4% of loss absorbing capability for the extremely leveraged positions that caused the financial crisis of 2007 / 2008, and that their total leverage will be capped at 33 times. Jenkins also highlights that the new rules being introduced on banking will not even come into effect until 2019.
The facts make for shocking reading, not least when studied beside Martin Wolf's article. Wolf reflects how "crises occur when what was thought to be low risk turns out to be very high risk." By comparison, Jenkins draws his audience's attention to two related subjects: the CDOs and innovative securitizations at the heart of the credit crunch, which were rated AAA by the leading credit agencies, and sovereign bonds, which Jenkins tells us may still be registered as "zero risk", despite the turmoil that has engulfed the Eurozone over the past two - three years.
So what is Jenkins' solution? He believes that all banks everywhere should be required to raise their equity capital to 20% of assets, a rate deemed optimal by many economists.
Wolf's article presents a somewhat pessimistic (aka realistic) view of banking reform: that bankers are unlikely to change fundamentally and that retail banks, despite their relative position of superiority over investment banks, in an ethical sense, also "misbehave". As a result, Wolf makes the case for methods that overcome "managerial insouciance" - the introduction of greater transparency - and which limit fallibility, that is to say, procedures that lower leverage. His is a case for a ring fence between retail and investment banking, to separate savings deposits and the capital required to finance investment banks, but not an all-out separation of retail and investment.
Jenkins' 20% ratio is a radical position, but one which, given the huge pain of the past 5 years and the lack of hope that things are going to get any better any sooner, is refreshing. I don't believe anyone buys the argument anymore that the financial services sector can self-regulate, or that the "free" market can adequately protect itself from the "hubris hungry and error prone" practices of the human race when it is at banking. It is time for serious proposals that clearly define what is permissible, but which are also implemented across national boundaries. Can you imagine a world in which ring fences were imposed for all retail and investment banking procedures, and in which the capital ratios were increased, internationally, to a level that precluded tax-payer bail outs of national financial institutions?
One thing is certain, the boom and bust of the financial services sector will go on. It is part of the ingenuity and creative re-birth of capitalism. Nevertheless, there must be a way to prevent the failures of individuals' judgment from becoming the national pain of millions of others. It is time to fight back against the argument that minimal controls "damage the economy". An overly regulated system is not the answer; smart regulation that is seriously implemented, is.