By Simon Johnson
Just when it seemed that the debate over banking was winding down – with overwhelming victories on almost all dimensions for the people who run the world’s largest cross-border financial institutions – two of the biggest name policy heavyweights have entered the arena. Both voices are typically listened to most carefully within official circles and yet their messages today are diametrically opposed.
Which one is right?
Speaking on the side of greater reform for the biggest banks, Mervyn King – governor of the Bank of England – gave a forceful interview to the British newspaper The Telegraph at the end of last week.
“Why do banks in general want to pay bonuses? It’s because they live in a ‘too big to fail’ world in which the state will bail them out on the downside.”
In Mr. King’s view, casino-type banking caused the crisis of 2007-08.
“Financial services don’t like the word ‘casino’, but instruments were created and traded only within the financial community. It was a zero sum game. No one knew which ones were winners when the crisis hit. Everyone became a suspect. Hence, no one would provide liquidity to any of those institutions.”
“We allowed a [banking] system to build up which contained the seeds of its own destruction.”
And “reform” efforts so far do not amount to much.
“We’ve not yet solved the ‘too big to fail’ or, as I prefer to call it, the ‘too important to fail’ problem. The concept of being too important to fail should have no place in a market economy.”
Mervyn King is an opinion leader among central bankers and typically a leading indicator of what other officials will be thinking in 6-12 months. He has also been instrumental in pushing the British government towards taking more decisive action against large banks that wish to continue operating with dangerously high levels of leverage (i.e., a lot of debt relative to their equity).
The banking policy debate in the UK remains wide open, with the independent Vickers Commission due to deliver a report in the summer, but the Bank of England is clearly on the side of wanting higher capital requirements – 20 percent is the headline number for tier one capital discussed behind the scenes (in contrast with the Basel III, which looks like to imply no more than 10-11 percent for systemically important financial institutions). The thinking of the Bank’s Andrew Haldane (responsible for financial stability) and David Miles (member of the Monetary Policy Committee) appears closely aligned with that of Anat Admati and her numerous top-level finance colleagues (if you haven’t looked at their work before, start with this page).
In the debate so far, only one voice has been raised that rivals Mervyn King in terms of reputation in the international economics policy community — Jacques de Larosière weighed in last week, publishing a high profile op ed piece in the Financial Times (see also this news coverage).
De Larosière is the former managing director (MD) of the International Monetary Fund, 1978-87 – and widely regarded as one of the best MDs that the Fund has ever had. His advice is taken seriously at the top level of governments.
But his views last week raised eyebrows because he came out so strongly in favor of Europe’s “universal banks”.
“With the exception of certain institutions in Switzerland, Germany, the Netherlands and the UK that excessively inflated their trading books, these universal banks have proved resilient through the crisis.”
It’s not clear why Mr. de Larosière skips entirely the difficult experience of big banks (relative to their economies) recently in Belgium, Ireland, Iceland, and Greece.
He cites the more positive experience in Canada, France, and Italy, but this is also odd – given that the Canadian success with bank regulation is largely a myth (as Peter Boone and I have explained), and the French banks were very much involved in the shadow banking system (remember that it was problems at BNP Paribas Investment Partners in summer 2007 that really signaled the start of a great financial unraveling; here is the company’s timeline and their press release at the time). Is Mr. de Larosiere really putting so much weight on the supposed success of Italian banks – with their large exposure to sovereign debt in Eastern Europe, in the Iberian Peninsula, and at home?
In the authoritative recent assessment of European banks by my colleagues Morris Goldstein and Nicolas Veron, there is no indication that banks in France or Italy were well regulated or better supervised. In fact, the unifying characteristic of the larger European banks is surely that they have become too big to be supervised effectively. If anything, the Goldstein and Veron work suggests that “too big to fail” is even more of a problem in Europe – with its universal banks – than in the United States.
According to Mr. de Larosière, new regulations more broadly and the capital requirements of Basel III specifically will have negative effects on the European economy.
“Given the cost of capital and the race for deposits, they [the banks] will have to increase the price of their lending, making credit more expensive.”
This looks very much like a variant on the line that bankers are putting forward (e.g., Bill Isaac, chairman of Fifth Third Bancorp, in the pages of the Financial Times, arguing for an increase in bank dividends) – positions that have been completely and directly refuted by Professor Admati and 16 other leading experts.
Who will prevail in the minds of officials responsible for financial stability in the US, Europe and elsewhere – King or de Larosière?
At least on the merits of the argument, King wins hands down.
But de Larosière has some powerful people at his back, including in his role as president of Eurofi. Eurofi describes itself as a think-tank but it appears to be more of a lobby organization, funded by huge global financial institutions (see the logos at the bottom of the page in that link), including Goldman Sachs, JP Morgan Chase, and Morgan Stanley from the American side. (Mr. de Larosière is also described on Eurofi’s website as “the Advisor to the Chairman of BNP Paribas, a position he holds since 1998” – although I understand he actually retired from this position in December 2008.)
Unfortunately, the latest indications from Europe suggest that the regulators are again caving to pressure from the side of big banks, allowing another round of weak stress tests that will do nothing to ensure there is a safe level of equity funding in the financial system.
An edited version of this post appeared this morning on the NYT.com’s Economix blog. It is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.