By: Sunil Datt, MS, MBA, MA, CGFM, PMP
Sunil Datt, MS, MBA, MA, CGFM, PMP, is Senior Managing Consultant, IBM Global Business Services.
When Mervyn King, Governor of the Bank of England, recently said: “Break up the banks,” I was inclined to hand him the hatchet; and set up a small business distributing hatchets to Ben Bernanke (chairman of the Federal Reserve) and other central bank chiefs around the globe. Since my writing about inattention to systemic risk in this weblog exactly 10 months ago, much noise and little action has taken place for addressing the issue (you see, secretly I was hoping that all central bank governors read this weblog). And more noise there was, as Alistair Darling, the Chancellor, opined with a stiff upper lip that “the situation was more complex” than what the Governor suggested, and his solution was “not right for the 21st century.” That last comment, of course, referring to the separation of banking from trading activities via the Glass-Steagall Act after the Great Depression. I was inclined to cheer for Darling’s modernist outlook, but then I realized that it is the practice to chose one side and cheer for it irrespective, as a ball is being kicked around, in the great British sport of soccer! But I digress; back to King’s argument.
Says King: “There are only two ways in which the problem can—in logic—be solved. One is to accept that some institutions are ‘too important to fail’ and try to ensure that the probability of those institutions failing, and hence of the need for taxpayer support, is extremely low. The other is to find a way that institutions can fail without imposing unacceptable costs on the rest of society. Any solution must fall into one of those two categories.”
His arguments against the first approach are convincing, and I will come to those. So logically, says he, we should let certain institutions fail, and his approach is to divide the large banks into the ‘utility’ bank and the ‘casino’ bank. The utility bank effectively provides for payments, deposits and loans; the casino bank undertakes some of the riskier financial activities such as proprietary trading. As we have a common interest in ensuring continuity of utility services, those banks can be considered too important to fail. The casino banks, on the other hand, can bear the consequences of their own actions. “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion."
One method under the first approach, says King, is of course higher capital requirements. But these reduce, not eliminate, the need for taxpayers to provide catastrophe insurance. Also, the “riskiness” of a bank’s activities and the liquidity of its funding can change suddenly and radically as market expectations shift. This means that what appeared to be an adequate capital or liquidity cushion one day appears wholly inadequate the next. “Indeed, the Achilles heel of the Basel regime is the assumption that there is a constant capital ratio which delivers the desired degree of stability of the banking system.”
The second method under the first approach would be to require banks to take out insurance in the form of ‘contingent capital’, that is capital in a form that automatically converts to common equity upon the trigger of a threshold that kicks in before a bank becomes insolvent. This is different from subordinated debt, which banks have been permitted to count as capital under the Basel regime, but which do not provide a reliable capital buffer until too late—after the bank has failed.
I think the insufficiency of Basel-type requirements by themselves containing contagion is by now widely accepted. The problem is that King’s proposal for the ‘utility bank’ and the ‘casino bank’ is fairly arbitrary too. Take for example, mortgages. If the utility bank originates the mortgage, and the casino bank buys the mortgage to develop and trade structured products (mortgage backed securities), what prevents the utility bank from generating ‘weak’ mortgages exactly as it happened recently, and the same problem starts all over again.
The real issue is the interconnectedness and the tight integration of global financial markets in today’s world. The dominos don’t stand individually and get knocked down one by one. They hold hands and dance together. And they infect each other virally. From that perspective, ‘smart’ regulation lies in a combination of better reporting requirements from all major financial players, highly automated processing of submitted data,, and sharp quick analysis to detect seeds of systemic risk. Stress testing all new financial instruments would be part of such a regime. Of course, the devil is in the detail, and a weblog is no place for that. So suffice to say, bury the hatchet King, there still is work to be done!
Nice title! Very apposite!
Posted by: another concerned citizen | October 30, 2009 at 11:36 AM