To secure stability, treat finance and fast food alike


Perhaps the most fundamental confusion in the evolution of financial services regulation is the equation of financial stability with the survival of established institutions. If I had a million pounds for every time I have heard a possible reform opposed because “it wouldn’t have prevented Northern Rock or Lehman Brothers going bust”, I might now have enough money to bail out a bank.

The objective of reform is not to prevent Northern Rock or Lehman going bust. It is highly desirable that organisations such as Northern Rock or Lehman should go bust.

Northern Rock had overambitious expansion plans and a business strategy that proved flawed (although many people thought at the time, with reason, that reliance on wholesale funding was a strength rather than a weakness).

Lehman was run (badly) for the benefit of its senior employees rather than customers or shareholders. In a market economy, such organisations fail while rivals with better business models and management structures gain at their expense. That process of selection is the reason market economies have an impressive record of promoting efficiency and innovation. The problem revealed by the 2007-08 crisis was not that some financial services companies collapsed, but that there was no means of handling their failure without endangering the entire global financial system.

Still, would it not be better if proper supervision ensured that no financial institution could ever get into a mess like Northern Rock or Lehman – or Royal Bank of Scotland or Citigroup or AIG? No, it would not. Just replace “financial institution” with “fast-food outlet” or “supermarket” or “carmaker” in that sentence to see how peculiar is the suggestion.

Begin with practicality. It is hard enough to find people capable of running financial conglomerates – the fading reputation of Jamie Dimon, JPMorgan Chase chief executive, confirms my suspicion that managing these businesses is beyond the capacity of anyone. The search for a cadre of people employed on public-sector salaries to second guess executive decisions is a dream that could not survive even the briefest acquaintance with those who actually perform day-to-day supervisory tasks in regulatory agencies. They tick boxes because that is what they can do, and regulatory structures that are likely to be successful are structures that can be implemented by box tickers.

We have experience of structures in which management or regulatory committees in Moscow or Washington take the place of the market in determining the criteria by which a well-run organisation should be judged, and that experience is not encouraging. The truth is that in a constantly changing environment nobody really knows how organisations should best be run, and it is through trial and error that we find out.

Financial stability is best promoted by designing a system that is robust and resilient in the face of failure, which is why effective and implementable mechanisms of resolution are the key to meaningful financial reform. Some progress has been made, but overall very little; living wills too complex to implement at all, far less within hours, are no solution to the problem of too complex to fail.

The bungled Cyprus bailout showed how far the EU is from the goal of an established resolution programme. The Cypriot parliament understood, even if supposedly more sophisticated policy makers did not, that deposit protection is the primary purpose of banking supervision. What people in the streets, correctly, understand by financial stability is confidence that their savings are safe.

Now we have an equally dotty, and essentially similar, proposal to fund the bailout of failed derivatives exchanges using customers’ collateral. The explicit rationale is that it is more important to keep the institution intact than to protect the interests of its customers. But the reverse is the case. The services may go on (or not: the commonest reason commercial organisations fail is that people do not want their product). But the failed organisation that provided such services need, and should, not.

This applies to fast-food outlets and supermarkets and car plants – and also to utilities such as electricity, water, and the payment system. Financial services differ only because the lobbying power of incumbent companies is so great.