19 June 2009

Mervyn King Seems to Get It

The more I listen Mervyn King, the more I get the impression that, as Governor of the Bank of England, he's had a reasonable understanding of the situation he's been faced with, but little real influence. One of his recent speeches has a lot of value in it[1]. Early on in the speech he highlights an effect of the current climate which, although it may have some negative elements, I generally think is quite positive.

Investors continue to demand high returns to finance banks. Put bluntly, market data on credit spreads imply that some banks are viewed as a worse credit risk than some of their customers. As a result, companies that can bypass the banks to access capital markets directly are doing so. Indeed, in the first four months of this year, more finance was raised in debt and equity markets than is normally the case in an entire year.

In this context, banks are risk externalisers; when somebody with money invests it directly in a business, they do so with an understanding that, if the business fails, they stand to lose some or all of their investment. When a bank acts as a middleman in that transaction, the person lending the money will often have an expectation that a proportion of their money is guaranteed to be safe, so the risks will be the same, but rather than the lender shouldering all the risk, it is shared by the lender and the taxpayer, who has to underwrite the guarantee. In that context, a shift towards direct investment is a positive thing as it internalises the risk, rather than socialising it.

King seems prepared to cut to the chase when it comes to national debt.

But five years from now national debt, as a proportion of national income, is expected to be more than double its level before the crisis. So it is also necessary to produce a clear plan to show how prospective deficits will be reduced during the next Parliament, so returning to a gradually declining path for the ratio of national debt to national income.

It's on the issue of banking regulation that he really hits his stride.

If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Something must give.

That sounds perfectly sound to me. I'm not keen on the idea of state guarantees generally, but if they exist, it seems especially unwise to offer them to the riskiest institutions. The frustrating thing is that the actions of the government have often run in the opposite direction to King's comments, encouraging the merger of Lloyds and HBOS being the prime example. Facilitating consolidation at the same time as bailing out banks because of their size displays ridiculously short term thinking, especially in an industry where the barriers to entry are so high.

Either those guarantees to retail depositors should be limited to banks that make a narrower range of investments

That sounds reasonable enough; if you want an extensive guarantee, then in return, you have to show that you're restraining your risk. That's what I'd expect from any other insurance policy.

or banks which pose greater risks to taxpayers and the economy in the event of failure should face higher capital requirements

Again, that's reasonable enough, although the caveat is that rapidly increasing capital requirements can increase the immediate demands on banks and damage their stability.

or we must develop resolution powers such that large and complex financial institutions can be wound down in an orderly manner.

This is where I think he really hits the nail on the head and it's something he expands on later in the speech.

One important practical step would be to require any regulated bank itself to produce a plan for an orderly wind down of its activities. That would provide the information to the authorities the absence of which made past decisions about the future of institutions difficult. Making a will should be as much a part of good housekeeping for banks as it is for the rest of us.

Attempting to completely prevent the failure of banks will always prove futile, so as a strategy it can never be more than a damage limitation exercise. The real need isn't to prevent failure, but to ensure any failure is orderly. Banks can happily be left to fail, so long as they don't end up externalising costs in the process. "Too big to fail" seems too sweeping a statement to explain the situation. "Too big to collapse" would probably be more accurate.

The one point at which King seems to understate the situation is:

Privately owned and managed institutions that are too big to fail sit oddly with a market economy.

I wouldn't say they sit oddly with a market economy, but that they are completely incompatible with a market economy. The strength of true market economies is that they evolve. The businesses which satisfy the demands of customers most effectively tend to succeed and those which don't fail. In that way, bad practices get forced out and good practices thrive. Like biological evolution, it may not be a completely smooth process, but it is effective. Guaranteeing the survival of a bank, no matter how unfit for purpose it is, stifles that process of evolution and begins to introduce some of the characteristics which make command economies so unresponsive.

1.
http://www.bankofengland.co.uk/publications/speeches/2009/speech394.pdf

1 comment:

DBC Reed said...

Bit of a side issue but arguments reliant on evolution are a bit tricky since it was accepted (post1980) that the dinosaurs (conglomerate banks?)did n't just fail to adapt to gradually changing conditions but suffered a mass extinction as a result of the earth being hit by a sodding great object.Evolution has itself evolved from Catastrophism (Cuvier) to Uniformitarianism (Lyell )back to Catastrophism with
a hint of gradualism.
Personally I'm on the side of the banks ( change denying dinosaurs? or adapting to changed circumstances?) AT THE MOMENT because they seem to be resisting pressure from the government to spray mortgage finance in all directions to secure a surprise Brown re-election.