, especially in revitalising retail banks and pushing ethics and fairness higher up the agenda.
The common ground is for higher and better capital and liquidity requirements, together with resolution and recovery plans, or living wills. Still under debate are whether to split casino and utility banks and how to cope with international banks in a failure.
Meanwhile, in a refreshing change of tone, commentators have started talking about ethics and morality as a business tool. With the discussions yesterday, this might ease some of the contradictions exposed by the crisis.
For example, there is the Osborne problem of wanting to tax banks to be popular, while also wanting them to lend and recover. Alistair Darling illustrated the dilemma this morning when he announced that LloydsTSB and RBS would have to sell some retail assets.
He said on the Today programme, when pushed on narrow banking, that RBS would keep its troublesome investment bank so the Treasury can maximise sale proceeds when it exits. Even if Darling were a fan of narrow banking (which he isn’t), he couldn’t have split RBS without destroying value for the taxpayer.
Then there is the philosophical contradiction between promoting fairness in markets and letting them develop under the caveat emptor banner.
Ken Costa, a long-serving investment banker and chairman of the church’s Alpha Course programme, will tell an audience tonight at Gresham College that business works best when the “golden rule” is applied of treating others as you would yourself.
Some say that since the City gentlemen’s code disappeared after the Big Bang, fairness has been a minority interest in business decisions. Indeed caveat emptor, which places personal responsibility (only for the buyer) before fairness, is the principle behind the light-touch regulation of recent years.
This now seems to be up for grabs. When Philipp Hildebrand, vice chairman of the Swiss National Bank, said yesterday that banks would make smaller returns on equity in future and be “frankly, more socially useful”, no one gasped in shock, as they had a few months before when Lord Turner said the same thing.
Even Josef Ackermann, chairman of Deutsche Bank and the Institute of International Finance, seemed comfortable with a more pervasive role for regulators. He told delegates that he agreed that regulators should in future assess the business models of banks, something they have never done in the past.
More resilient
Lord Turner’s main proposal for resilience is to jack up equity capital and liquidity. Everyone agrees on the principle but not the levels. The silence about numbers suggests a negotiation is coming. If they do well, regulators could emerge from this with the power to close down whole areas of activity just by lifting capital requirements.
Turner dismissed what he called “extreme narrow banking”, where utilities are regulated but casinos are not, because he believes the casinos still need regulating. The Treasury agrees, citing the chaos after the failure of casino bank Lehman.
On this, Darling and Turner are singing in tune with the big banks. Joseph Ackermann, a major beneficiary of the big bank model (he is famous in Germany for referring to his multi-million payments as “peanuts”) said any systemically important bank must be bailed out, whether casino or utility. He then went on to warn that the public would never escape as ultimate guarantors of the whole bank system. This could have sounded quite sinister from anyone else, but Ackermann knows how to charm a crowd.
So instead of a full legal split, Turner prefers Paul Volcker’s version of narrow banking, reflecting the spirit of Glass-Steagall as banks divide themselves internally through their living will arrangements and regulators apply different capital rules and bail-out plans to each part.
Better behaved
Good for resilience, but how do you make the banks behave better? On the retail side, John Kay argued that one of the main benefits of a split would be so retail banking could improve. Deposit-taking banks could focus on customers instead of the earnings and capital needs of a universal bank. Set them free from their casino masters, he says, and they would no longer chase commissions by selling the wrong life insurance to their customers. Instead they could invest in better payment systems and sell products that really fit their customers.
Darling is trying to bring about the same thing by selling retail assets from RBS and Lloyds, but without a split he'll have to do a lot more.
On the investment bank side, the US is working on a proposal where banks commit to a shared rescue fund. This would take some of the burden away from the public and create a strong incentive for banks to control each others’ risky behaviour.
Ackermann said he would like the cost of this to be shared with the public, repeating his favourite horror line that there is always a public backstop. He earlier warned, without a hint of irony, that “there are limits on the financial risks that the rest of the financial system can bear”.
And here lies the opportunity. If banks had to provide their own rescue fund, then regulators could link the size of that fund to leverage ratios or other metrics in a way that limits risky activity to the size of the insurance.
This would scale back financial activity, but, based on Turner's other comments, that's a price worth paying for stability. “If banks choose to remain smaller and simpler, that is fine,” he said about the effect of capital charges. “If they result in a reduction of trading activity that will be a quite acceptable effect,” he said about tighter rules and an exchange for OTC securities.
Fairness
In the Turner review, the FSA wrote: “Regulators ... should be willing to consider over time whether particular markets have characteristics sufficiently harmful, and benefits sufficiently slight, as to justify intervention.”
This looks like intervention on the grounds of social utility, where the costs to society outweigh the benefits. It is radically different from light-touch regulation.
After a preamble about how financial activity has doubled as a percentage of GDP since 1992, and graphs showing the huge increase in financial sector leverage in the last decade, the Turner review says:
"The possible harmful effect is rent extraction. For it seems likely that some and perhaps much of the structuring and trading activity involved in the complex version of securitised credit, was not required to deliver credit intermediation efficiently. Instead, it achieved an economic rent extraction made possible by the opacity of margins, the asymmetry of information and knowledge between end users of financial services and producers, and the structure of principal/agent relationships between investors and companies and between companies and individual employees.” (section 1.4(v))How might a utilitarian approach have affected the recent US debate about credit default swaps, one of the chief culprits in the crisis?
Part of that debate was about whether these instruments should be issued only to owners of the underlying credit. The bank lobby successfully argued against this change so CDSs can still be used in amounts far exceeding the underlying credit, a recipe for speculation.
A regulator that compared the benefit of slightly more flexible hedging with the bail-out might have decided differently.
I doubt there's a remit for such analysis in the UK, but if the idea of fairness in regulation is extended to include fairness to society, perhaps this might change.
The discussion of narrow banking highlighted two other ways for regulators to exploit the interface between casino and utility banking. One is in the "cloudy" border where normal loans and mortgages are repackaged into exotic securities. The other is treasury trading, which according to John Kay differs from proprietary trading only in scale and intent.
If a bank funds its loans through securitsation, regulators could let the securitising bank do so only in proportion to the loans raised, rather than in proportion to demand for the bonds, which could have more to do with budget deficits and exchange rates than the need for credit.
This would mean abolishing trusts and other open ended structured finance vehicles, and limiting the chain of re-securitsation through the CDO market.
With treasury and prop trading, it would be relatively simple for regulators to ban speculative treasury trading. When the size and strategies of such trading look suspicious, or where treasury pay is linked to trading profits, they could deem it speculation and assign a capital surcharge.
Easier to clean up
Sparing taxpayers from future bail-outs was a central concern at the conference. Turner spoke of the “unfairness of a socialisation of losses after what have often been very large private gains”, while Hildebrand warned that a failure to reform would “bequeath future generations a serious risk of a worse crisis.”
Turner also mentioned some unfairness around debt and noted that we have an “unwillingness to impose any losses on debt capital, even though it is there to absorb losses.” He wants only equity and contingent capital, if the Basel Committee allows, to count towards the new capital requirements. In practise that means far more equity is needed, which will drive down shareholder returns.
This is likely to increase risk appetite among managers but if Basel approves contingent capital, which turns into equity in a bust, there would be another group of investors pushing to keep risk down.
I assume the FSA is not at the moment interested in abolishing tax relief on interest, which would give debt and equity the same tax treatment and restrict credit growth. That may be a little too hot with an election round the corner.
Living wills look like a sure bet and the FSA is already working on pilot schemes for UK banks and preparing itself for robust challenges on the content of resolution plans. If implemented well, the resulting internal divisions at banks would allow much better targeting of capital rules. Living wills could also stop universal banks from gearing up on depositors capital and take much of the burden of failure away from taxpayers.
As Turner said, there is no silver bullet. But the opportunities to revitalise retail banks, make investment banks self-insuring, and adopt a more society-friendly idea of fairness in regulating financial activity could give regulators a silver ammunition belt.
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