Thursday, 12 February 2009

Good Banks Needed

With the luxury of hindsight it’s easy to see the first signs of what should have been done to tackle the present financial crisis. Savers - the innocent party in all this mess - should have been protected. And the core issue - toxic debt - squarely addressed. Until that is solved, credit markets will remain blocked, lending to consumers and businesses will remain inadequate and the real economy slide towards depression. Almost everything the government has done so far has treated the symptoms of this problem. Not the root cause. In a well argued piece in today’s Times Anatole Kaletsky urges exactly this point, but falls short of the right solution.

When gridlock in the wholesale credit markets first emerged back in summer 2007 - more than 18 months ago - re-capitalising the banks should have been the governments only priority. This is a debt crisis. No amount of liquidity will alter untradeable and seemingly unquantifiable toxic debt on their balance sheets. By abolishing taxes on savings, a natural cascade of private money would have allowed balance sheets to be at least partially re-built and savers rewarded for their prudence and self-sacrifice.

A lot of comment has also centred on ‘protecting’ taxpayers from banking excesses by re-introducing Glass-Steagall type legislation separating ‘safe’ retail banking functions from inherently risky investment banking activities at the heart of our present problems. The return of Captain Mainwaring is widely called-for. But as anyone can see, smart and effective regulation will keep stuffy and arrogant amateurs like Captain Mainwaring safely on our TV screens, not in our banks.

In truth the vast majority of investment banking functions – fund management activities, equity, bond & foreign exchange trading and traditional corporate finance functions like mergers & acquisitions – are perfectly legitimate banking activities that any properly integrated financial institution should be able to offer corporate clients. They may be inherently more risky than asset-backed lending, but even with existing regulation, could never produce the toxic mess which has blocked credit lines and now holds the entire economy to ransom.

This is the result of a small band of largely unregulated financial wizz-kids more interested in securing short-term multi-million pound arrangement fees (which provided their bonuses) by layering ‘clever’ and now largely unquantifiable financial instruments – preferably with three letter acronyms that only they could ‘understand’ - on top of securitised debt. These should be regulated out of existence.

But we are where we are. And with the benefit of hindsight, protecting taxpayers from the stupidity of bankers is exactly what we need. Just not through ineffective 1930’s style legislation.

Our starting point is debt. And no amount of additional debt, whether through wildly expansionist monetary policy – which initiated and continues to underpin our current problems – or through a massive fiscal stimulus, will in any way address the core issue. This government has yet to recognise the real problem and until it does, it is incapable of providing a solution. The government is – and always has been - part of the problem. Running around like headless chickens announcing daily policy initiatives which saddle the country with even more debt may make Gordon Brown feel happy, but it does not address the real problem. Until that happens we continue on the road to a deep and lasting depression. What is needed here is leadership and vision. As Jeremy Clarkson pointed out last week, Gordon Brown is incapable of either.

If large toxic debt is the problem, what then is the solution? Firstly, look at the size of those toxic debts. Several trillion dollars which would overwhelm the financial capabilities of taxpayers for several generations. Buying up toxic debt is not an option we should be considering. It simply rewards banks for failure and socialises debt to the taxpayer. Too much moral hazard there.

In an excellent explanation by
Willem Buiter - further expanded on 8th February - a practical and equitable solution to the banking crisis is offered in the form of a split between ‘good’ and ‘bad’ banks. It is supported, with small variations, by George Soros and Joseph Stiglitz among others and has already been successfully used by the IMF in the Uruguayan banking crisis of 2002. As Monica B. de Bolle, a commentator on this article wrote:

“I thought you might be interested to know that something akin to your model was applied in Uruguay to resolve the banking crisis of 2002. As a result of both contagion from Argentina and some degree of mismanagement at the affected institutions, the Uruguayan banking system came under severe stress in late 2001/2002, leading to the failure of the country’s four largest banks. To resolve the crisis, the authorities embarked on a massive bank restructuring operation (with support from the IMF, where I was working at the time on the Uruguayan team), which involved creating a new (temporarily state-owned) bank out of the "good" assets and liabilities (deposits) of the failed institutions. The old "bad banks" kept the non-performing assets and were effectively transformed into asset management companies, responsible only for managing the assets and attempting to recover whatever was deemed "recoverable". The operation was hugely successful in restoring stability to the Uruguayan financial system.”

I will leave the above links to explain the full intricacies of such a scheme. No doubt further details would need to be sorted out to scale-up and apply this model to western banking systems, but by using taxpayer’s money to support new lending – not throwing it down the drain on unquantifiable toxic debt – we address the real issues. We stabilise the banking system. We achieve our “…medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective” as Buiter puts it, and finally we achieve an equitable solution that is fair to the taxpayer: “the polluter pays or, you break it, you own it.” Furthermore, it commits the taxpayer to a fraction of the costs being currently demanded by those profligate bankers and their political masters currently in government. Additionally, it allows the prospect of a future return on taxpayer’s money, whilst putting its supporters on the right side of the argument - supporting new lending and borrowing, not the interests of the bankers.

The two failed banks – RBS and Lloyds – now substantially owned by the taxpayer - should immediately be fully nationalised. Each should be split into ‘good’ banks (NatWest and Lloyds?) whilst the toxic mess at their heart is ring-fenced into ‘bad’ banks (RBS and HBOS?) which the current crop of directors can manage as best they can. No doubt they’ll find some way of paying themselves bonuses.

The taxpayer-owned and capitalised ‘good’ banks by contrast, with clear unblemished balance sheets, can begin to lend confidently to a credit-starved economy. They already have an extensive geographical branch network. They are already involved in the full range of banking functions. And with carefully designed regulation, they can begin to provide the banking services whose absence in the last eighteen months has turned Gordon’s recession into Brown’s depression. Tackling that will have to wait for another article…

Tuesday, 10 February 2009

Contrite bankers

Two issues arising from the Treasury Select Committee’s performance today:

Notice how at every answer given, the UK regulatory authorities – the FSA – were intimately involved in, and agreed to every decision taking those businesses forward. Whether decisions over debt, the management of risk, the takeover of ABN-Amro or the over-reliance on wholesale funding. The FSA were there. They discussed and agreed banking activities at every stage of the business, from proposal through to implementation. The question we need answering is whether the very backing of the government’s highest regulatory authority at every stage of this disaster might have actually emboldened those banking executives to continue digging the hole in which we now find ourselves.

Secondly, each banker consistently maintained that the credit crunch – the drying up of wholesale credit markets between banks – was solely responsible for the economic disaster we now find ourselves in. Not their company’s performance or business model - far less their own competence in valuing debt.

The credit crunch of course, is seen as an ‘external’ problem. Something they could never have foreseen or in any way have prevented. So that’s ok then. They’re off the hook. It was beyond their control. That’s a pretty qualified apology by any standard.

At root, the credit crunch is a failure of confidence. An inability by banks to trust the financial integrity of other banks with whom they need to trade credit in order for the banking system to operate effectively. And why such mistrust? Because the banks themselves took on and traded the now-toxic debts that lie at the heart of this problem. And what was responsible for taking on those debts? The wizard financial acumen of those very contrite bankers.

Friday, 6 February 2009

Responsible Bonuses

Why such ridiculous criticism of banking bonuses? Of course we want bankers to be incentivised. We want them to focus diligently on not just repaying taxpayer’s money – which bailed them out - but profitable returns thereafter. What we don’t want is short-term cash bonuses based purely on a percentage of their department’s P & L account for the last 12 months. Lets leave that in the age of irresponsibility.

The government must insist that all bonuses are paid in share options, struck at today’s market prices and exercisable in two years time. That way, bankers have an incentive to build the business and grow taxpayer’s (and shareholder’s) money over the longer term. And if that individual should leave the business beforehand, they forfeit all such options.

Sunday, 1 February 2009

Polly Toynbee

Polly Toynbee, talking on the Guardian’s ‘Politics Weekly’ podcast this week about the future prospects for Labour party support if the Conservatives won the next election:

“I think it would build pretty quickly though, because I think what you would find is, the Conservative party coming in - in say 2010 - will be in such deep trouble, it would have to make huge cuts in services, and won’t be able to make huge tax cuts. People will really feel the pinch, whoever is in power. But Labour suddenly has a real cause at that point. This is back to the 1980’s - Mrs Thatcher’s notorious budget of 1981. It’s going to feel like that again and I have a feeling that will have a rallying effect on a lot of the people who’ve left Labour, coming back again.”

So there you have it. A newly elected government “…in such deep trouble” after thirteen years of Labour rule, having to make “…huge cuts in services”. Just as Labour has already committed itself to do after the next election. Indeed this weeks Institute for Fiscal Studies report suggests there will need to be an additional £20 billion in cuts (or tax rises) over and above the government’s PBR totals. But unlike Labour’s promised cuts in public services and already announced tax rises, a Tory one will take us “…back to the 1980’s”.