The response of politicians to the financial crisis has been like a fight breaking out in a bar. Legislators have preferred to hit those they have always wanted to hit (hedge funds and private equity) rather than those who started it (the banks and regulators that failed). Their actions over the past four years have done little to restore confidence and little to kick-start growth. As a consequence the global economy is stuttering, while some stock markets are now at levels not seen since the months before the crisis, propped up by ever greater quantities of money being printed in London and Washington.
Proof legislators have not learned the lessons of the crisis is evident in their response to every new crisis. More than five years after the run on Northern Rock in the UK and four years after the collapse of Lehman Brothers, failing banks across the European Union are still being bailed out by taxpayers. The challenge for policymakers should be to create a competitive and free market in financial services which provides its customers with choice and value, and which does not have to turn to the taxpayer for subsidy.
Reinventing the financial culture
Politicians, central bankers, and regulators were as culpable as management in allowing the banks to develop a culture of risk denial. Central bankers reduced interest rates and ushered in cheap money; politicians proclaimed the end of boom and bust and encouraged the mortgage bubble; regulators and bank management teams bought in to the idea you could ‘engineer’ risk out of existence by using ever more complex financial instruments which few people really understood. New compensation schemes and deposit guarantee schemes convinced people their money was safe regardless of where it was invested or deposited.
We need to reinvent a culture where risks are recognised and shouldered by bankers who take responsibility and accept the consequences of the actions of their institutions. In a truly competitive market, banks and financial institutions that were over-exposed would have failed. The profitable bits of their businesses would have been bought up by rivals or new entrants and the rest left to disintegrate. Their destruction and dismemberment would have given way to newer, healthier businesses.
Paying for failure
Despite the mutual back-slapping among politicians for introducing a new (and bigger) regulatory architecture, the fundamental problem remains. Banks are still failing and being bailed out by taxpayers. I would recommend four new measures to try to save the taxpayer from paying for failure and to introduce more stability into the banking system:
1. Governments need to state clearly that enough is enough: no more bank bail-outs ever.
Without sending a strong and clear message to banks that they will never again be bailed out, bankers will not believe it. To underline this clear intention, two further policies are needed and work has already begun on them. Supervisors will need to spell out procedures to wind down failing banks without taxpayer funding or disruption to banking services and Governments should legislate for a separation of wholesale banking activities from retail activities. At the very least, the savings of retail investors should never be used to subsidise the trading by investment arms of banks. The ring-fence needs to be resilient and high, for example, as recommended in the Vickers Report in the UK and similarly by the Liikanen Commission at EU level.
2. Make directors more liable for failure.
One of the main reasons for the unpopularity of the banks and poorly thought out regulation in recent years is the perceived refusal to accept fault on the part of the bankers. It is even harder to vote out bad bankers than bad politicians!
It is unacceptable for individuals who presided over failure to avoid facing the consequences of their actions. Measures to improve corporate governance are, of course, welcome, but a far simpler and cleaner solution would be to force the management of financial institutions to take a personal interest in ensuring their employees only take risks that are reasonable. We could investigate the feasibility of returning to the partnership model where directors are directly liable for failure. Other options include paying directors in the form of bonds so that they pay the price for failure.
3. Encourage more transparency in banking.
Most savers are still under the belief that their savings are actually held by the bank with which they deposited them. In fact they are usually loaned out in order to generate both revenue for the bank and interest for customers. If bank customers know that institutions will be allowed to fail, then banks are more likely to make their operations and charging structures more transparent to earn their customers’ trust.
Transparency should result in a system of three types of tiered-risk/reward bank accounts. Deposit account or standard retail banking, where you pay a fee but are guaranteed to be able to get your money back. Loan or bond account banking, where the bank admits that your money is not on deposit, but is loaned to it in return for an agreed interest rate. Or Money market or investment banking, where the money is invested in the stock market, managed funds or other complex financial instruments and could make a profit or be lost.
4. Reform accounting standards.
Investor groups argue that the International Financial Reporting Standards which have been used prior to, during, and after the crash, have clearly not given a ‘true and fair’ account of a bank’s balance sheet. The discount many banks are currently trading at against their stated asset value may reflect this mistrust.
Investors are concerned that the IFRS has encouraged a move away from the principle of prudence, whereby accounts must not overstate assets or understate liabilities, profits should only be booked once they are realised, and sufficient funds are put aside to cover any potential losses. This convention has been replaced by an American-inspired principle of auditor neutrality, where accounts are deemed ‘true and fair’ if they have ticked all the boxes required by the IFRS.
Box-ticking failed to spot financial institutions recording expected income from complex financial instruments in advance. Financial institutions failed, or had to be bailed out, since they simply did not put aside enough funds to cover their exposure to credit default swaps and collateralised debt obligations. AIG Financial Products was able to build a portfolio of $2.7 trillion (£1.7 trillion) in derivatives, resulting in liabilities many times its capacity to pay out.
Accounting practices should be reformed to ensure they provide a genuinely ‘true and fair’ view of balance sheets, with appropriate levels of loan loss provisioning in place. This means returning to a system of accounting in which accounts are only signed off when the company is a going concern. The liability implications are potentially far-reaching for auditors and directors, but this should in turn be a driver of better governance.
All this will take time and we have not yet made a proper start. If we can achieve these four objectives, then finally we may have learned the lessons of the crisis and go on to create a more competitive and transparent banking system, where both bankers and savers act more diligently.
This article is an extract from an essay in Banking 2020: What kind of banking system will we have? which was recently published by the New Economics Foundation