Tough love is the best regime for failed banks

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The notion that private companies can extract indiscriminate, industry- wide support from the public for the benefit of their investors by threatening that their weaker members will collapse is intolerable in any sector.

The British government, planning to privatise water utilities, was forced to recognise that these could not be like other businesses. If a hairdresser, or a burger bar or even a car plant failed, the shop or factory would close. But if a privately owned water company failed, it would not be enough to post a notice on the reservoirs and sewage treatment works telling potential customers to contact the liquidator. Even if the flow of cash to the business ran dry, the taps must not.

So for water and some other utilities there is provision for a special administrator with the responsibility to ensure continued service. There are other commodities for which financial problems of the provider cannot be allowed to interrupt supply. It would be intolerable for a bankrupt care home to turn its residents in to the streets or for a failed hospital to abandon patients. An airport cannot tell aircraft not to land until its banking facilities have been renewed.

Ad hoc solutions to these problems are usually cobbled together in haste. A shotgun marriage is arranged with a solvent institution or a financial bail-out is organised. But these are not satisfactory solutions. They rely on co-operative competitors or indulgent taxpayers. However, modern businesses are hard-nosed and finance ministries may be reluctant to write blank cheques. These rescue schemes do not give enough protection to customers and give too much protection to managers and investors of the failing concern.

A hard budget constraint means you shut when you run out of cash; a soft budget constraint means that when you run out of cash you lobby for more. Bankruptcy is the hardest of budget constraints, although provisions such as Chapter 11 soften it – perhaps too much. Failing organisations argue for constraints to be softened. They are too big or too important to fail, like Chrysler or Alitalia. They are too complex to fail, like Eurotunnel, or too embarrassing to fail, like the Royal Opera House.

But all these claims threaten fundamental market disciplines. Organisations are better run when the budget constraints they encounter are hard. The transformation of British Airways and British Steel in the 1980s was not the result of privatisation – transformation preceded privatisation, and made it possible. The change occurred when Margaret Thatcher made it clear that she did not care whether these organisations continued in business, and a soft constraint suddenly became hard. The change in management attitudes was immediate.

The concept of special administrator was designed to keep budget constraints hard. Weak organisations could not wield the threat of consequences for customers in order to extract money because financial failure would not imply a loss of service. The procedure has been used once – when Railtrack collapsed. It was at best a partial success. Trains continued to run, so that the primary objective was achieved, but the complex and conflicting obligations of the administrator meant that a year elapsed before a new, more effective management could be put in place.

Still, the principle of special administration is a good one and it needs wider application. Customers are the priority and the financial consequences can be argued at length. The priority of customer service should hold even at some cost to shareholders and creditors, who take that risk in return for the potential rewards of investing in essential public services.

Not by coincidence, the industries for which a special administration regime is appropriate are mostly subject to scrutiny by specialist regulatory agencies. That agency should have the responsibility to put a special administrator in place if needed. The existence of a supervisor is a good guide to the sectors where that need might arise: utilities, infrastructure, health and education – and financial institutions that deal directly with the public.

The notion that private companies can extract indiscriminate, industry- wide support from the public for the benefit of their investors by threatening that their weaker members will collapse is intolerable in any sector. And it is most intolerable when the sector is as profitable as financial services.

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