Some Humble Suggestions

What, then, should be done?

Even granted the power to determine the future structure of the financial system, the answer is far from clear. Not only because charting a course from where we are now to some ideal alternative will always be exceptionally difficult, but also because the nature of that alternative is, at best, rather elusive. It’s a topic about which people of goodwill (and deep understanding) will continue to have widely varying opinions.

Before offering some suggestions on what a more sensible financial system might look like, it may help to first review some of the vital issues that ought to be borne in mind when considering such a redesign. Most have, directly or indirectly, already been raised.

1) Credit Isn’t Always a Good Thing:

The most important, for me, without doubt, is that credit in and of itself isn’t a good thing. More than that, unless it represents the temporary transfer of real savings, it’s likely to do more harm than good.

To take an illustration near and dear to the hearts of most Australians, consider the impact of the great explosion of credit in recent decades on housing. Yes, it brought about the construction of more, and larger, homes than would otherwise have been built and enabled some people to purchase a home who might otherwise have been unable to do so. Against these benefits (granting for now that they are), there are, however, many costs.

Over the last 20 years real house prices (that is, adjusted for inflation) have risen by about 250%. In relation to real average household income, real rents and real construction costs, they’ve doubled or more (all figures from the 2008 National Housing Supply Council State of Supply Report). Looked at from another angle, in June 1989 the value of all household dwellings was 123% of GDP. In June 2009, the same ratio was 310%.

So, has the quantity and quality of housing really improved that much? Clearly not. There is, however, a powerful correlation between the jump in household debt and the equally impressive leap in housing prices. The simple truth is a great many of us have borrowed a whole lot more, and most of it has gone to buy existing houses and apartments. Again, a few figures: from June 1984 to June 2009, housing debt as a percentage of disposable income rose from 26.5% to 137.5%1. Note that during the interest rate crisis in the early 1990s, that figure was still only 35.6%. It’s not hard to imagine the fate that would befall many homeowners today if rates went even half as high.

Cui bono? Well, other than smart (or lucky) speculators who bought more real estate than they needed way back when, I’m not sure anyone really benefited. Everybody else is either living in an asset that seems to be worth a lot more (but we all have to live somewhere, right?) or struggling to find a way in without hocking themselves to dangerous levels. Is this societally productive? Hardly.

There are other, more subtle, but perhaps ultimately even more damaging effects. The traditional Australian preoccupation with owning one’s own home became, in the last decade, an obsession with real estate more generally. Vast amounts of energy, and resources, were devoted to playing this game, all at the cost of more fruitful and productive activities. Encouraged by continuous credit induced (and often spectacular) price appreciation, many considered themselves far more wealthy than they actually were, and spent accordingly. This heightened Australia’s traditional problem with low savings, and so contributed to a deteriorating current account and the systemic fragilities that follow.

Now in fairness, Australia’s banking system (together with a few others such as Canada’s) has weathered the crisis without much disruption. There were good reasons: the excesses of subprime lending were largely avoided, both in terms of domestic origination and the purchase of exotic overseas securities; banking leverage was not extreme; regulation was tighter and more effective; both economies benefited from their strong commodity export orientation; and, in Australia’s case at least, government indebtedness was (and still is) extremely low, and early and aggressive steps were taken to stimulate the economy.

Whether this (partly deserved) good fortune holds in years to come is another matter. The level of household indebtedness in Australia is as high, or higher, than anywhere else in the world, as are housing prices in relative terms. It’s a potentially lethal combination.

In any event, if we could only wean ourselves from the deep-seated conviction that credit is a good thing which needs to be constantly encouraged, and instead concern ourselves more with its nature and quality, we’d be at least halfway towards putting together a sensible financial system. Even more importantly, we’d be far less likely to fall prey to the sort of delusions that have so bedevilled us in recent times.

2) No Good Is Likely to Flow from a Highly Geared Financial System

A corollary of this acknowledgement would be the acceptance that no good is likely to flow from a highly geared financial system, certainly not when it comes to depository institutions. In addition to the systemic risks that arise from such gearing, it also necessarily means that a great deal of non-savings based credit is created, with the many distortions and malinvestments that follow.

The best way to bring about a more conservatively geared depository system isn’t quite so straightforward.

Proponents of 100% reserve free banking (all three of them, some would add) believe such a structure (in which banks are compelled by law to always hold reserves equal to all call deposits, but are otherwise subject only to standard commercial laws) would not only achieve that end, but would also do so with the least fuss possible.

In the absence of a lender of last resort, and given the rate of credit creation would tend to be set by the most conservative banks (since, through the process of daily clearing, banks expanding credit more rapidly would equally quickly lose reserves to their less adventurous fellows), a specie based, 100% reserve2 free banking system would probably be both surprisingly conservative and require only the most light-handed regulation.

However, given that such a system would be unlikely to work outside of a specie standard, and given the immense intellectual leap of faith that would be required, it is in my view almost certainly (albeit perhaps unfortunately) a non-starter.

Still, something useful could be salvaged from this approach, namely the idea of restricting banks’ right to lend against shorter term deposits. This would not only slow the process of credit creation (its growth tends to be tightly linked with the degree of maturity transformation) but also increase systemic stability by more closely matching borrowing and lending durations.

There are in any case a multitude of ways in which much lower bank gearing could be targetted, if first that goal were accepted as desirable. Straightforward leverage limits are clearly one (and are in fact being discussed in some regulatory venues), as are revised and stricter risk weighted schemes, which are also under discussion.

Unfortunately, one of the great difficulties with all schemes to control banks is that they all too easily become increasingly complex, prey to gaming and regulatory arbitrage, and of course subject to heavy duty political lobbying (the JP Morgan’s and Citibank’s of the world play for keeps). Unless and until there’s a sea change in attitudes towards credit, it’s hard to see a sensible, streamlined, effective and durable structure emerging. These matters may become moot, of course, should a truly serious deleveraging eventually unfold, as I think is quite likely. In the aftermath (for a generation or so at least), credit would be about as popular as it was from the 1930s to the 1950s. That is, not at all.

3) Bank Creditors Should Be at Risk

Creditors of banks should be put on notice that in future their capital will be at risk, not only because it’s right that risk and reward should bear some relationship to each other, but also so they’ll be more likely to exercise some restraining influence on banks getting carried away.

One of the more grievous errors made during the depths of the crisis was to load the burden of bailing out the financial system onto taxpayers while giving creditors a free pass. It’s easy to see why depositors should for the most part be exempted (to do otherwise would have been to induce panic and unilaterally change the understood rules of the game), but creditors of failing banks should either have been forced to take a haircut, or had some portion of their holdings converted to equity. Not only would this have had the salutary effect of boosting capital at no public cost, but the bank’s indebtedness would have been reduced at the same time.

As well as playing hell with the public finances, this decision ensured that public faith in the fundamental fairness of the official response to the crisis was profoundly undermined, and understandably so. Whether it was done out of fear and panic, or because of the uncomfortably close relationships between government and the major players in the financial system, I don’t know, but the “fat tail” costs of this decision are likely to be very high indeed.

4) Separating Commercial Banking

There’s a lot of debate about whether commercial banking functions should be separated by law from capital markets activities such as trading and other principal risk taking. In the US at least, these two types of activities had for the most part been separated from 1933 until the repeal of the Glass-Steagall Act in 1999.

Under a system where governments did not (and would not) bail out failing financial institutions, there’d be little reason for such mandatory separation. Many depository institutions would voluntarily choose to stay out of all principal risk-taking, not only to enhance their own chances of survival, but as a marketing strategy to conservative depositors. The market would almost certainly over time evolve different institutional strata categorised according to risk (and presumably return).

Realistically, however, can any of us imagine a government ever standing by while depositors lose their funds? Here’s Paul Volcker, speaking before the Committee on Banking and Financial Services on September 24th last year:

“Experience, not only here but in every country with highly developed, inter-connected financial systems and institutions bears out one point. Governments are not willing to withhold financial and other support for failing institutions when there is a clear threat to the intertwined fabric of the financial system. What can be done is to put in place arrangements to minimize the extent of emergency intervention and to damp expectations of government “bailouts”.”

His proposed solution is to separate commercial banking, where government support in an emergency is in practical terms inevitable, from other financial activities, where (with sufficient prior notice and legal clarification), calls for support can perhaps be resisted:

“As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e. taxpayer) financial support, certain risky activities entirely suitable for our capital markets. Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Some trading, it is reasonably argued, is necessary as part of a full service customer relationship. The distinction between “proprietary” and “customer-related” may be cloudy at the border. But surely by the active use of capital requirements and the exercise of supervisory authority, appropriate restraint can be maintained.

The point is not only the substantial risks inherent in capital market activities. There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships – individuals, businesses, investment management clients seeking credit, underwriting and unbiased advisory services.”

Given the political realities, Volcker’s suggestions seem eminently sensible.

Such an approach (presuming it also prevented commercial banks from engaging in OTC derivatives activity) would in addition go some way to resolving the profound dilemma of interconnectedness. The unknown and inextricable degree to which the biggest international universal banks were intertwined (both with each other and throughout the markets) via derivative contracts made it almost impossible for the authorities to consider putting any of these major financial institutions through some form of restructuring. Particularly when time was short. They quite simply couldn’t estimate the systemic consequences of, say, putting a Citibank into liquidation.

Clearly this is intolerable. Taxpayers should not be forced to underwrite open-ended, complex, high risk and essentially unregulated activities.

5) Ratings Should Be Depoliticised

Finally, ratings should be depoliticised. As things stand, ratings provided by major firms such as Moody’s and Standard and Poor’s are intricately woven into the fabric of a multitude of financial and investment regulations. Financial institutions were often forced (or at the very least strongly encouraged) to act in certain ways, and to not act in others, all on the basis of the ratings applied to various instruments and securities.

Governments should not give such an imprimatur to private agencies. Quite apart from leading to many absurd and ultimately destructive decisions, it granted effective monopoly rents to a few private companies. Any prescriptive (or proscriptive) regulations and laws should as quickly as possible be cleansed of their reliance on ratings. Should institutions still wish to rely on them, it would then be their private affair.


1 Reserve Bank of Australia (B21: Household Finances – Selected Ratios).

2  There are two schools of thought on whether free banking needs to be based on 100% reserves. Those who maintain it doesn’t (and I’m one) have quite a few successful historical free banking episodes to back their claim, including Sweden in much of the 19th century, Canada in the late 19th and early 20th centuries and Scotland from 1716-1845. All were impressively stable and relatively non-inflationary.

Free banking was shunted aside more because of politics and ignorance than any defects in the system itself. The case for it was also fatally undermined by the frequent failures of banks under systems that superficially resembled free banking but were in fact severely handicapped by regulatory flaws (such as the US through much of the 19th century).