COLUMNISTS The debate on bank regulation risks becoming slightly theological in character. On the one hand, justice must be seen to be done and bankers must pay for their sins. On the other, tinkering with free markets is of the devil, and the nation that attempts it is on the road to perdition.
Rather than enlarge on that, I propose three more modest questions. Does the system need reform right now as opposed to later? Does it need new laws and institutions on top of the existing ones? And – a lesser but still interesting question – what effect might necessary action have on bank shares?
As to urgency, some would say unreformed bankers will promptly repeat their follies next time round – that a dog, as the Bible has it, returneth to his vomit. No doubt. But it might take longer this time.
A chart from Morgan Stanley shows US credit market debt as a proportion of gross domestic product since 1929. Private sector debt peaked at 230 per cent of GDP at the start of the Great Depression. It then plunged to less than 50 per cent at the end of the second world war.
It then rose to about 270 per cent by 2005, the latest date shown. It may now be that credit is again starting to contract – or, as Graham Secker of Morgan Stanley puts it, that we are in a period of structural deleveraging rather than a normal debt cycle.
No one now in the markets has any experience of such a thing, nor any real idea of how it might play out. But however keen bankers might be to return to their folly, it could be a while before they have the ammunition to do it.
So if we have time for reflection, how best to use it? For a start, the mess between regulators could be tidied up.
In the UK, the split responsibility for banks between the Bank of England and the Financial Services Authority should surely be fixed.
In the US, where Bear Stearns has revealed a similar muddle, the simple answer – as Barack Obama said last week – is for the Federal Reserve to have “basic supervisory authority” over any institution to which it is lender of last resort.
Bear Stearns, by the bye, is the rebuttal to those who want the Glass-Steagall Act revived. That was introduced alongside deposit insurance, so that while taxpayers might have to bail out savers, they should not be exposed to the antics of brokers and investment bankers.
But Bear Stearns shows they now have such exposure in fact, so Glass-Steagall is a dead letter.
Tidying up those loose ends is mainly a matter of improving existing laws and institutions rather than bringing in new ones. So what else?
First and foremost, the Greenspan doctrine that regulators cannot address asset bubbles looks obsolete, as the president of the Minneapolis Fed hinted last week. At its root is the premise that the market price is always right and that regulators have no basis on which to challenge it.
But as Viral Acharya of the London Business School points out, the latest bank rescues contradict that.
In taking on failing institutions’ assets, governments are implicitly saying the market price is wrong – as in many cases it patently is.
So why cannot they say the same when prices are daft in the other direction?
Any dealer could have told the regulators ahead of the credit crisis that risk was mispriced and subprime mortgage rates crazy.
Indeed, the Bank of England warned for months that UK banks were taking on too many leveraged loans, and would be left on the hook if securitisation dried up.
Yet the issuance of such loans peaked just ahead of the crunch. The Bank was powerless to avert that, in part because it was not the banking regulator.
It was also because its principal remit is to curb inflation, and this was not an inflationary problem.
Plenty to address here, then – but all within the existing framework. The main thrust of improved regulation should be to slow the banks down – to cap their leverage, to make them post reserves against off-balance sheet vehicles and so forth. Given that the cycle will eventually resume, the trick is to reduce risk to the taxpayer.
Finally, what about bank share prices? Putting a brake on profits might seem damaging.
Yet in the four years to 2007, Bear Stearns’ earnings per share more than doubled – but its price-earnings ratio never got above a pitiful 13 or so. Investors knew those rocketing earnings were based on leverage and risk-taking, and adjusted the price accordingly.
If the banks were obliged to conduct their business in a saner fashion, it would certainly be good for taxpayers. It might not do investors much harm either.
