Political Economy

On the 27th September 2009 I made a speech to the English Democrats AGM and autumn conference entitled “  The ABC of Banking Regulation” (http://bit.ly/u2vCYM). I made the speech because as I said, “It [the bank crisis] happened because we had the lightest touch, and probably the most dysfunctional, bank regulatory scheme going”. The recent report on the Royal Bank of Scotland failure (the RBSR) by the Financial Services Authority, who were responsible for regulation, appears to agree with me.

Overall I am happy with the progress to date. Some of the matters I suggested have turned up as proposals or have been enacted. But we still face tough times and there will have to be a greater degree of  implementation of these ideas if we are to build a stable base for the future.

My A was accountability. I suggested that in order to achieve this we should have something akin to the Sarbanes-Oxley Act in the USA. The difference would be that bankers, the directors and senior managers, would go to prison for 5 years and suffer a £5,000,000 fine if their bank needed saving by the authorities. I still think that this is the one regulatory change that would ensure compliance with prudential banking practices. The RBSR is suggesting fines and exclusion from working in banks again for those who transgress. This is far from enough.

I had two Bs, both of which have been taken up by the coalition government. First was to put the Bank of England in charge of the regulation of banks and other depositary institutions. The second was based on a law in cybernetics called “Ashby’s Law of Requisite Variety”. Put simply this states that any regulator must have as wide a range of control measures available to it as there are ways of change in the system. The economic system is, and always will be, subject to wide gyrations that we call “boom and bust” caused by a variety of events. The regulatory authority must have a similar wide range of responses available and not just, as in the Bank’s case, the ability to raise or lower interest rates to control inflation. The coalition’s response to this suggestion has been the “Financial Policy Committee” which has wider powers of intervention.

I had three Cs; clarity, capital and compensation.

Clarity referred to stopping the ability of banks to create opaque, multilayered derivative product that are sold “over the counter” and thus in secret. The dangers are self-evident. The opaque nature of the the security makes it much more likely that that collapse will occur and the secret nature of the transaction means that banks do not know who holds this toxic junk and so will stop lending to other banks, the so-called “contagion” effect. The Frank-Dodds Act in the USA is in the process of moving these transactions to open exchanges where much greater clarity exists. The final report of the Independent Commission on Banking (The Vickers Report) has proposed the banning of dealing in derivatives by the ring-fenced commercial arms of banks whilst the investment banking arms going through a process to improve clarity, somewhat.

It became clear that banks relied too much on borrowing and not enough on their own capital as well as having a deficient method of risk calculation, which would in itself lead to too little capital. I was being far too optimistic. The RBSR infers that there may not have been any risk calculation on occasions.

The new rules under Basel III will increase capital levels and the UK wants to increase the levels of capital held by larger banks even more (the EU on the other hands wants to reduce the levels of capital proposed). It was clear that increasing the levels of capital would result in lower level of lending and liquidity in the banking system. This is very evident in eurozone banks, where the appalling level of management of the system, has meant European banks withdrawing cash from the international system where its effect will be felt not just in the EU but in developing countries as well as elsewhere in the world.

I suggested that some of the problems of increasing capital could be overcome by requiring (investment) banks to insure against sudden, but infrequent, requirements for increased capital. This could be done by a mixture of government and private sector insurers, provided that the premiums that go to the government are deposited in a ring-fenced fund to keep off the sticky fingers of politicians who, when it comes to giving goodies to voters using someone elses money, can show a degree of “stickiness” that far exceeds that of your average banker!

The third C is compensation. I suggested that commercial banks could be subject to a significant regulation including control of compensation. In return directors and senior managers would not be subject to custodial sentences if the banks needed saving. The RBSR suggestions concur with my mine on this matter.  The question of excessive compensation is still an issue and solutions are still being discussed. There is no sign yet of criminal penalties, a situation that needs to be speedily changed.

My D was for division. I felt then, and still feel, that investment banks and commercial banks must be split. The Vickers report is recommending a half-way house of strict firewalls. I hope this succeeds but fear it will not. We should remember that investment bank are by nature risk taking and piratical institutions. If they were not they would not be successful.  Whilst a group of greedy investment bankers have within their line of sight a pile of someone elses money sitting in deposits they will move heaven and earth to get their hands on it. The subterfuges they will employ will often not be discovered by the regulators who will end up being powerless to stop it. Only the strong threat of a prison sentence could have any hope of stopping this behaviour.

If we are to have a strong banking regulation system in a sea of lighter touch regulation it will be all too easy for the banks in the later environment to undercut UK regulated banks in their product and service pricing hence leading to a decline in English banking. To do this we need to take powers to tax companies, fairly, that have used foreign products that are cheaper due to easier regulation. This should not extend to taxing solely on the basis of cheapness, some of which is due to efficiencies. There is no sign of this yet. This was my F

My L was for government to stop being lead by the nose by bankers and to start leading themselves. This, at least in the UK, but not it would appear in the EU, is starting to happen.

The score to date is zero for A, two for B, two halves for C, a half for D, a zero for F and one point for L, a total of four and a half out of nine suggestions or 50%. We still have a long way to go. It will be interesting to see what emerges.

 

GHTime Code(s): nc nc 

27th September 2009

Single handed Gordon Brown has all but ruined England.

His hatred of the English, his incessant greed for power, his insane fixation on getting re-elected at any cost, his fear of rivals and almost paranoid attempts to “fix” things in his favour, his willingness to lie, to Parliament and the country, in order to achieve his own selfish ends, his inability to see the wood for the trees in all he does, but most of all, his mismanagement of the economy and of the financial system, have made of him a political monster almost without peer in English history.

Last month the government deficit was £16 billion – enough, in one month, to almost replace the Trident fleet. It is now running at an annual rate of £192 billion as against the Treasury figure of £175 billion.

We live today in the biggest economic shambles of all time.

Banks have £680 billion in toxic assets some 85% of the worst are likely end up in the governments Asset Protection Scheme causing some commentators to talk about a ‘massive fraud’ on the taxpayer

Why did all this happen?

It happened because Gordo allowed the mother-of-all credit booms in order to ensure his election to the premiership.

It happened because the UK had the most globalised banking system, and hence the one most open to the worlds financial risks,

It happened because we had the lightest touch, and probably the most dysfunctional, bank regulatory scheme going.

Something urgent and something significant has got to be done.

Don’t get me wrong. Commercial banks, the sort that lend to industry and consumers are absolutely vital to any economy.

They give borrowers access to the savings of the nation in an orderly manner and their lending activities increase the supply of money in the economy, which as the early 19^th century English economist Ricardo said “Oils the wheels of industry”. Without commercial banks you cannot have an economy in England that would support 25 million people let alone the 50 million we have.

But without a safe, regulated, commercial banking system you have an unstable economy. Mervyn King said in an interview some months ago that the regulators just did not have the tools they need to manage the situation.

Why? It has been 233 years since the publication of the ’Wealth of Nations’ and 315 years since the founding of the Bank of England.

So, why has this crisis occurred?

Well for Mervyn and the ‘Heavenly Duo’ (they come from ‘up there’ after all) here is my Alphabet of key Bank Regulatory changes.

A is for accountability. It is absolutely vital that the boards that run banks are held accountable, not just to their shareholders, but to the nation as well. They have in the US something called the Sarbanes-Oxley Act where by the CEOs and CFOs of businesses that falsely state they have an acceptable system of internal financial control which they have personally reviewed, can go to prison for up to 5 years and be fined up to $10 million. Notice that no business failure or fraud has to occur, only making a false statement.

This is the minimum penalty that should be applied to the boards of banks and there should be no wiggle room. If the regulator decides the bank needs saving then this is prima facie evidence in court.

B is for the Bank of England. It should be given the responsibility for regulating banks and other depositary institutions. The current system splits the responsibility 3 ways and has to go.

B is also for Booms. The bank must be given responsibility for controlling booms just as it is does inflation.  The Bank controls the rate at which retail prices rise and it should also be able to control the rate at which a range of other asset prices rise such as housing.

This is not just an idiosyncratic notion. We are attempting to control an economic and financial system. In the science that covers the control of systems there is Ashby’s law of Requisite Variety.

Put simply this means that for each variety of activity in the system the system regulator must have an equal variety of responses. Financial and economic systems go through booms and busts, bubbles and crashes. If you do not control both you control nothing.

C is for clarity. Without accurate information financial systems cannot work. We should no longer allow Banks and other institutions to create complex derivative products and then sell them privately so that no one knows what their exposure to the assets is and what the true risk is.

C is also for capital. In the event banks were vastly undercapitalized. Capital requirements need to be changed and this in turn requires our understanding of risk to change.

It is a technical matter but the world of mathematical finance has known since the PhD thesis of the French statistician Louis Bachelier in 1903 that current measure of risk underestimates the true risk by factors of 10 to 20! When Long Term Capital Management went bust in 1998 it complained of variations 25 times higher than normal. As a result banks are always chronically under capitalised. They will have to have more.

Banks should have to take out insurance against running out of capital the premium for which will be proportional to their risk as well as size.

Perhaps three Cs are too many but there is one more important one. Compensation. In return for being more closely regulated and accepting strict limits on compensation, commercial banks would not be open to criminal charges

The boards of investment banks will be open to criminal charges and therefore the only controls should be on bonuses and a requirement to relate pay to long-term returns.

D is for Division. We have to separate the commercial banks from the investment banks. In the UK our major commercial banks failed because they also had investment banking arms. Investment banking is by nature risky and we should never again allow the commercial banks, on which individuals and businesses rely to be brought down by investment banking activities.

F is for Foreign Governments. There is a great deal of international competition to attract as big a financial sector as possible.

Gordo in part made his reputation by the simple expedient of, in effect, saying to banks “Come here and do business and I will allow you to get away with whatever you want.”

Part of the regulatory powers will need to be the ability to limit companies operating in England from getting finance from banks operating under a lighter touch regulation elsewhere, perhaps by imposing penalty tax rates directly on those borrowings.

My final letter is L. L is for liquidity, that is the amount of cash held by the banks. In the year 2000 this was only 2% of sterling deposits and less than 1% for of sterling assets. This has to increase perhaps to 10% and banks will have to pay for their deposit insurance, with the premium related to their size and risk.

My final prescription is L for Leadership. Currently the bankers are leading governments around by the nose. This has to be reversed.

There are many other proposals that could be mentioned. We need to remember that we cannot get rid of booms and busts. But we can have a framework, that calms the boom, catches the bust before it becomes to big and puts the bankers that through their greed and negligence caused the problem, in prison.

GHTime Code(s): 2925c