The suggestion by the Dutch finance minister that the bungled bailout of Cypriot banks was part of an evolving new approach to financial crises shocked markets. But is it possible Jeroen Dijsselbloem is right to suggest that there is a fundamental change in public and political attitudes to bank bailouts?
In the past year the reputation of banks has hit a new low. The bust in the eastern Mediterranean followed exposures of the fixing of the London interbank offered rate and the $6bn losses on the JPMorgan Chase “London Whale” trades; each different in proximate cause, each representative of a rotten culture in parts of the financial system.
Barclays came under attack for both Libor manipulation in wholesale markets and the mis-selling of payment protection insurance in its retail arm, showing how a trading culture could spread poison through a larger organisation. JPMorgan’s failure of risk management showed that even in the best-run financial conglomerate, senior executives had – and could have – little knowledge of what was really going on. Cyprus dispelled any illusion that international bodies had acquired the authority or competence to deal effectively on a co-ordinated basis with even minor problems.
The time and energy devoted to reform since the crisis developed has barely begun to address the fundamental issue of organisational culture. The belief that the right response to the failures of Basel I and II is a more elaborate version of the same global regime is a triumph of hope over experience. The EU has tackled the problems of its banking sector by devising restrictions for private equity and hedge funds.
The most important political response has been the socialisation of the losses of financial institutions. The “Geithner doctrine” in the US provided an assurance that no systemically important group would be allowed to fail. In Europe, markets interpreted the statement by Mario Draghi, European Central Bank president, that he would do “whatever it takes” as an affirmation that, however imprudent the policies of governments and banks in the eurozone, EU institutions would come up with the cash in the end.
The combination of useless regulation, irrelevant regulation and state guarantees met the perceived needs of regulators and the industry itself by creating an appearance of activity while reinforcing the status quo. But the inevitable result was that the crises kept coming.
An effective package of reform has three central interlinked components: resolution of failed institutions; restructuring of financial conglomerates; and substantial recapitalisation of the whole sector. And these issues are – belatedly – becoming part of public debate.
The principle of resolution should be that neither political democracy nor economic efficiency can tolerate institutions too big to fail. That requires realistic plans to break up struggling cross-border institutions and the capacity to impose losses on uninsured creditors as well as shareholders. Most of all, it demands recognition that, in banking as in the rest of the market economy, the normal fate of failed commercial institutions is to be wound up.
This goes hand-in-hand with structural reform; too complex to fail is no more acceptable than too big to fail. Separation of retail and investment banking will reduce the cross-subsidy arising from mingling taxpayer-guaranteed deposits with speculative exposures, and limit contamination of the everyday business of financial intermediation by the culture of trading.
And, as a recent book by Anat Admati and Martin Hellwig explains, banks need more capital – lots more capital, not minimal provision based on a pseudoscientific calculation of risk-weighted assets. Neither regulators nor management can assess accurately how much a bank really needs. The only safe bank is one with more capital than it could possibly require. Like banks of old.
In other industries, this is taken for granted. BP had sufficient capital to withstand the Deepwater Horizon incident, not because the energy company or its regulators anticipated such an event but because it had enough capital to withstand the most costly disaster to hit any company anywhere. We will have effective reform of financial services only when we stop thinking everything about them – from capital structure to regulatory mechanisms to remuneration – is sui generis.