By Roger E.A Farmer
The US is in the process of implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. In the UK, the Vickers Commission has released interim recommendations to “ring-fence” the retail operations of banks from their investment banking activities. The Vickers report is a model of clarity and if the ring fence proposals are implemented, they will have bite. But there is already a push from Lloyds to weaken the proposals of the interim report and that is only the opening salvo. The pressure from financial institutions for lax regulation will be intense. That pressure should be resisted.
The proposed reforms of both the Dodd-Frank act and the Vickers report will increase the amount of capital held by financial institutions by reducing leverage. Increased capital requirements will reduce the probability that any given institution will fail but they will not eliminate the moral hazard problem created by implicit government support for large financial institutions. That requires a more radical reform of the kind I have argued for elsewhere.
High capital requirements do not prevent financial institutions from seeking risk; if anything, they exacerbate the problem. Bob Diamond, chief executive of Barclays, is shooting for a return of 13 per cent on equity next year by taking on more risk. This may please Barclays’ shareholders; it should not please the UK taxpayer since Barclays’ investment strategy involves gambling with deposits that are backed by the public purse. Unlike Lloyds and RBS, Barclays was not bailed out by the government. But a successful past is no guarantee of a successful future and it does not mean that Barclays should be given carte blanche to gamble with taxpayer money.
Mr. Diamond is on record as arguing that banks should not be bailed out. That’s a bit like arguing that a doctor should not treat a person who catches smallpox because the unfortunate victim was not prescient enough to buy insurance. Financial crises are like epidemics. If one bank becomes infected by a crisis of confidence, others will follow. Nobody wants to see a return to 19th century capitalism where bank failures and financial crises occurred with alarming frequency. Regulators understand this problem and bank bailouts are here to stay, although, it may be possible to design a regulatory system that allows individual banks to fail while protecting the system as a whole.
Retail banks raise capital from savers and lend that capital to small businesses at a profit. By making riskier loans, a bank can demand higher interest rates from its creditors. This leads to higher profits on average for the bank’s shareholders. But because risky loans have a higher probability of default, sometimes the equity holders will lose money.
If a bank’s loans are extremely risky, its equity holders may be wiped out when there is a financial collapse. But in modern day regulated economies, the holders of savings deposits do not suffer; their savings are insured by government guarantees.
Deposit insurance does not only benefit savers, it also benefits the equity holders of the bank. When savings deposits are guaranteed, it is much easier for a bank to raise capital. There was no outcry from depositors when Barclays declared that it planned to take on more risk, precisely because high street customers are not exposed to that risk. If there is another financial meltdown, it is the British taxpayer who will step in to pick up the pieces.
In response to a wave of bank failures during the Great Depression, the US passed the Glass-Steagall Act, a comprehensive piece of legislation that introduced Federal Deposit Insurance. As a consequence of that legislation, private individuals were able to have confidence that their money was safe, even if the bank in which they invested went bust. Uncle Sam, through FDIC, would bail them out. In return for deposit guarantees, the Fed placed restrictions on the kind of investments that a high street bank could make. “Casino banking” was ruled out by law for any bank that accepted federally guaranteed deposits.
In 1999, many of the provisions of the Glass-Steagall act were repealed and the US entered a new era of universal banking. Under the new legislation, investment banks were able to compete for retail deposits and commercial banks were able to invest in high yield assets such as mortgage backed securities and other forms of collateralised debt obligations. The financial deregulation of 1999 occurred in response to an intense lobbying effort from financial institutions. It was also backed by the then Fed chairman, Alan Greenspan. Wall Street bankers argued that deregulation would lead to higher growth by providing a broader fund base to support lending.
Why should one oppose the universal banking model? Surely a return on capital of 13 per cent is not unreasonable as long as there is enough equity in the bank to absorb potential losses. Perhaps. But when deposits are protected by government guarantees, there is an incentive for a bank to compete for customers by offering savers a higher rate of interest than its competitors. The most successful bank is the one that takes on the most risk. Ring fencing assets will not remove that incentive since the retail arm of the bank has the same incentive to seek risk as the investment banking arm.
Current opinion among financial regulators is that the problem of financial instability can be solved by imposing higher capital requirements on banks. But higher capital requirements cannot prevent banks from taking excessive risks. In the 2008 crisis, commercial banks speculated in the US housing market by buying low grade mortgage backed securities that were mistakenly rated as triple A by the US ratings agencies. Somebody was asleep at the wheel.
I am not opposed to financial institutions taking risk. Risk is an integral part of the engine of capitalist growth. But Barclays, and other deposit taking institutions, should not be allowed to gamble with private deposits that are insured by government guarantees. There is a strong case to be made that effective reform requires the complete separation of retail and investment banking. That separation should be accompanied by restrictions on the assets that can be held by any institution that relies on government guarantees. Restrictions of that kind were part of the Glass-Steagal act that led to 60 years of relative economic stability. Dodd-Frank and the Vickers report make significant steps towards restoring the protections of Depression-era legislation. In my view, they do not go far enough.
Related reading:
Independent Commission on Banking interim report
Roger Farmer is chair of the economics department at UCLA and the author of two books on the global economic crisis. How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, is written for the general reader and specialist alike and Expectations, Employment and Prices is written for academics and professional economists. Both are published by Oxford University Press.
© Roger E. A. Farmer
Disclosure: Martin Wolf, the FT’s chief economics commentator, is a member of the Independent Commission on Banking
