Tuesday, 30 August 2011

Unholy alliance

It appears that Angela Knight, head of the British Bankers' Association, thinks that now is not a good time for structural reform of the banks to make them less dangerous to life and liberty in the event of their failure.

It also appears that John Cridland, chairman of the Confederation of British Industry, thinks the same.

Knight argues that reforming the banks now, when the economy is dodgy, the stock market is volatile and the Eurozone is imploding, would delay economic recovery. She wants banks to concentrate on making money so that they can "pay taxpayers back".  Implementing structural reform to reduce risk can come later, apparently.

That's bonkers. We are facing a banking crisis that could make Lehman look like a minor flurry. The imperative to reform banks to ensure that they can fail safely has never been stronger. Delay economic recovery? Disorderly failure of unreformed banks wouldn't just delay it, it would cancel it for a generation. And how come paying back taxpayers has suddenly become so important? It hasn't been exactly high on banks' agendas for the last three years.

Now, I am by no means convinced that the reforms proposed by the ICB will have the desired effect of making the banking system safer. I think they are half-baked, to be honest. I have written about this extensively, most recently here.  But to leave things as they are is the worst possible option. The ICB's recommendations, weak and flawed as they are, are better than nothing.

Knight's opposition to reform is no surprise, really. She speaks for the banks. The banks don't really want to make any changes that mean they will make less money.  So this is simply the latest in a long line of attempts to derail the process of reform. 

What is more surprising is John Cridland's support for her views. According to the Guardian, he fears that introducing a retail ring-fence will "stem the flow of credit to businesses".

Amazing. So he fears that the banks won't be able to raise the extra capital they need to reduce the risk of catastrophic losses from dodgy lending, so will have to stop lending - not that they were doing much anyway. Maybe he thinks (hopes?) that bank lending isn't dodgy any more, so there's no need to make it safer. Or has he bought into bank scaremongering? They have argued from the start that retail ringfencing and higher capital requirements will reduce the availability of credit. I dispute this. I see no reason why ring-fencing should reduce lending - unless, of course, banks can't raise the extra capital required. Higher capital requirements do increase the cost, of course. But that's already happening: banks have already increased the spread between borrowing and lending rates to enable them to retain more profits without reducing shareholder dividends.

Whatever the reasons, Cridland's objections are as specious as Knight's. And there seems to be a distinct shortage of common sense around.  Yes, the economy is fragile. But the risks to the banking system are the single greatest threat to economic recovery.  Some sort of reform - even a half-baked one - is urgently needed. The Government should ignore both Knight and Cridland and get on with the job.

Two takes on the Tyranny of Democracy

This morning, on twitter, I saw this blog from Richard Murphy: The Tyranny of Democracy.

And right next to it, in another column, I saw this blog from Tim Worstall: The Tyranny of Democracy.

Of course I had to read both of them, didn't I?

Fascinating. Tim Worstall's blog was, of course, a rebuttal of Richard Murphy's arguments.  And I have to say that in general I agree with him on this one.

The Tyranny of Democracy is not purely concerned with taxation, as Richard Murphy suggests. As Tim Worstall says, it is to do with the tendency of majorities to impose upon, discriminate against and abuse minorities.  To the extent that in our parliamentary democracy, the government is elected by the majority (and I'm aware that there are issues around that), minorities will always be at risk.

Imposition of draconian taxes on minorities has happened at various times in the past in the UK. Worstall gives a recent example of such a tax. I prefer to mention the continual milking of the Jews to fund military campaigns by successive kings in mediaeval times. Such taxes are as much an abuse of human rights as denial of voting rights, jobs, education, healthcare, benefits and liberty to minorities.  Oh, and very often financial abuse goes along with systematic denial of other rights as well, particularly the right to argue and resist.

Now, I'm not arguing that wealthy people paying more tax is necessarily a denial of their human rights. But what if the top tax rate rose to 98% - as it did in the 1970s? At what point does tax policy stop being reasonable and become abusive? Wealthy people are unquestionably a minority, after all. If they weren't, we wouldn't be having this discussion, would we? Wealthy people need representation too. Otherwise it is all too easy for them to become a target for the envious poor.

I really don't think Murphy's argument - that libertarians fighting their corner amounts to an attack on democracy - stands up. They have a right to express their opinions and attempt to influence policy through debate and persuasion. We all have that right.  Denying that right to someone because you don't like their politics, or their religion, or their gender, or their colour, or the amount of money they have - now THAT's an attack on democracy.

Oh, and I have no axe to grind here. I am not, and never have been, wealthy.

Monday, 29 August 2011

Setting up banks to fail: retail ring-fencing revisited

In my quest for a blueprint for bank reform that would allow dinosaurs to die quietly without endangering people's lives and finances, I found myself re-reading the Independent Commission on Banking's (ICB) draft report yesterday.  I always find it interesting to return to something I haven't read for a while, as I nearly always find something that I missed before. This was no exception.

In fact I don't know how I missed it before. On re-reading the report it is very evident that the ICB's recommendations for increased capital and retail ring-fencing have little to do with keeping banks running safely and efficiently. They are intended to make it easier and safer for them to fail.

And they don't mean just investment banks, either. The aim of the retail ring-fence is to enable government to take over the running of essential banking services (payments, access to deposits, lending facilities) for ordinary people and small businesses in the event of ANY bank failure, whatever the cause. You see, the problem with running an integrated retail & investment banking model is not that one funds the other, or that one increases the risk of the other. It is that you can't easily separate functions that are essential to the smooth running of our economy from those that are not, nor from those that have global rather than domestic impact. That is the real reason why the Government found it necessary to bail out banks rather than allowing them to fail.

On that basis, I applaud the ICB's efforts. But they don't go far enough, and there is - as I have noted before - a cost, both financially and in terms of increased risk, particularly to retail customers. 

Let's look more closely at their recommendations and the reasons for them.

According to the ICB, "making the banking system safer requires a combined approach that:

••makes banks better able to absorb losses;••makes it easier and less costly to sort out banks that still get into trouble; and••curbs incentives for excessive risk taking."


And in recommending ring-fencing of retail banking as a solution, they say the following:

"Ring-fencing a bank’s UK retail banking activities could have several advantages. It would make it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions – reorganisation or wind-down – were found for other operations. It would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And in combination with higher capital standards it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking."

See what I mean? Most of this is concerned with closing down failing banks. Only the reference to drawing on investment & wholesale banking to save retail operations, and the reduction of the taxpayers' guarantee to improve risk management, is about keeping them going.

Note that the above quotation mentioned the possibility of failing RETAIL operations being bailed out by wholesale and investment banking operations. This is not pie in the sky. Three of the four UK banks that failed did so because of serious losses in retail banking. It is essential that banks that have wholesale and investment operations can draw on them if necessary to support retail banking.  One of the reasons for the ICB's opposition (and mine) to full legal separation is that that would make it very much harder for banks to do this, and there would consequently be increased risk to RETAIL customers.

It is unfortunate that the way in which this report has been represented in the media and by politicians gives the impression that it is a blueprint for protecting "safe" retail banking from "risky" wholesale and investment banking. It is nothing of the kind, and hysterical demands for full legal separation to "prevent bankers gambling with our retail deposits" are a million miles removed from the careful analysis and balanced arguments in this report.  To quote the ICB again (my emphasis):

"...the Commission believes that there are practicable ways of distinguishing between retail banking and wholesale and investment banking. Both sorts of banking are risky and both are important, but they present somewhat different policy challenges."

I have previously written about the ICB's proposals for retail ring-fencing. As a model for banking in the future I still think it is seriously flawed, relying as it does on the integrity of bankers to keep risks manageable. The increased capital requirements overall and separate capital requirement for retail operations go some way towards mitigating this, but the fact remains that retail deposits will still be at risk.  And the existence of deposit insurance backstopped by the taxpayer will still encourage bankers to take excessive risks in lending, knowing that if it all goes wrong the taxpayer will cough up. 

However, as a model for ensuring that failed banks can be safely wound down and essential services maintained, I have to admit it has some merits. And since we are currently facing the possibility of a mammoth banking crisis due to sovereign debt writedown, imposition of a ring-fence in the short term would provide retail customers with some protection. But it doesn't go far enough. In particular, it is unacceptable that current accounts remain "at risk" in the same way as deposit accounts.  As I have noted in another place, these accounts are the lifeblood of our economy and people need constant access to them. Nothing is proposed either to ensure that these accounts cannot fail under ANY circumstances or to compensate people for contingent losses arising from lack of access to these accounts.  The FSCS scheme is utterly inadeqate as insurance for current accounts.  I would prefer to see current accounts separately ringfenced and treated as custodian accounts (i.e. off balance sheet), so that banks cannot use them to support any commercial activity.  And I would also like included in the ICB report discussion of appropriate measures to enable investment and wholesale operations to be safely resolved, losses mitigated and risks managed.  After all, large amounts of our savings pass through these operations. Global failure of investment banking could wreck our pensions, our ISAs and our endowments.

And finally....the ICB does not discuss funding of retail operations at all: it appears to assume that funds arise only from deposits, which is far from the truth.  There are strident calls for retail banks to be denied access to external funding sources such as the interbank market and bond issuance: many of these calls arise from a mistaken belief that retail banking deposits fund investment banking, so retail banks can't be short of cash, can they? Oh yes, they can. Most retail banks require external funding on a daily basis. Liquidity crises are possibly the most serious threat to retail banking.  How would liquidity be maintained in a ring-fenced model? As, despite my qualms, it seems likely that some form of ring fence will be imposed, I shall return to this in a subsequent post.

Sunday, 28 August 2011

Regretful criticism

I have never before written a blogpost in which I have severely criticised the writing of another person, and I do so now with a heavy heart. But I really can't let this nonsense pass.

In a blogpost a week ago, Richard Murphy called for nationalisation of the banks.  He said:

"Of course we can save the banks, again. We can print money. We will have to.

But this time let’s get real. This time we don’t lend them that money. Or give it to them as quantitative easing."

There are two howlers in here, of course:

-  We didn't "lend" banks money. We provided it to them in return for equity. As a consequence two   banks were fully nationalised and we have substantial equity stakes in two more.  As with all equity investments, there is no guarantee that we will ever get our money back - it depends entirely on the eventual sale price of the remnants of Northern Rock and our stakes in RBS and Lloyds TSB.

-  Quantitative easing was not "given" to the banks. It was used to buy securities - which are now held by the Bank of England, increasing its asset base.

However, correcting Murphy's errors isn't the point of this blogpost. It's the appalling suggestion that the UK government should take over organisations whose collective assets total more than four times the UK's GDP.

When I pointed this out to Murphy he brushed it off, claiming that of course when you nationalise you only take on equity, and no compensation would be paid to shareholders. This is true. But when you nationalise you also take on the balance sheets of the organisations you buy.  The UK would end up owning trillions of pounds worth of potentially toxic assets. After all, he is proposing nationalisation to prevent financial collapse, isn't he?

Yes, I know we could print lots of money to cover the inevitable losses on those assets. Or we could issue huge amounts of lovely new government debt.  But if we're going to do that I would much rather it was spent on something useful. Something that really benefited the people of the UK. Not - absolutely not - on propping up failed institutions.

And the most bizarre part of Murphy's writing comes not in the post itself but in the comments.

I commented on his post:

"Yes, I can disagree. Nationalising banks would leave taxpayers owning $trillions of dodgy assets with no prospect of writedown in any way that doesn’t mean more taxpayers’ money going to the very rich. I for one don’t want any part in that."

He invoked the financial armageddon argument, of course, to justify his position, thereby ignoring the fact that there are other options that could be considered to avoid catastrophe. And he claimed that there's no such thing as taxpayers' money. Weird. But not as weird as the next bit.

I reproduce this in full for the amusement of my readers.

From another commenter called Stevo!!! in response to Murphy's reply to my comment:

"Write the debts down and turn them into equity! The debts are mostly commercial paper. Create enough money to buy them and replace the legitimate debt with cash or number money. All you would be doing is replacing these debts with the equivalent money value, therefore not creating any new money. Write any illegitimate debt off as unrecoverable."

This is odd enough. The commenter clearly doesn't know the difference between assets and liabilities where banks are concerned. But Murphy's response is priceless:

"Since debt is money your logic is sound".

Now, I did say "assets", didn't I? Bank assets are money it has LENT. If the people, companies or - most likely, in this case - countries can't pay the loans back, those assets become worthless and have to be written off.  It is total nonsense to suggest that they can be "written down and turned into equity".  Writing off bad debts is an immediate hit to profits, which if it results in an overall loss would have to be absorbed by reduction in shareholders' capital. In other words, we would be on the hook for potentially HUGE losses on our investment.

You'd think an accountant would understand that, wouldn't you?

I would like to think that Richard Murphy would take this criticism in good part. I do not mean it as a personal attack but as a genuine contribution to the debate that we need to have about the best way to deal with our dysfunctional financial system.  But I am not hopeful, sadly.



Saturday, 27 August 2011

Why are they doing it that way, anyway?

In this blog I am stepping outside my comfort zone, so if I have made any glaring errors, please be kind! But in following the various horror stories, screams of outrage and complacent comments of "I told you so" arising from ATOS's assessments of fitness to work, one thing puzzles me. Why on earth has the Government engaged an external company to do this work, no doubt in return for handsome remuneration, when it already has a huge workforce that is more than capable of undertaking these assessments?

I refer, of course, to GPs.

GPs have access to patient medical records - which ATOS don't. For those claimants who are actually sick, their GP will be the person who manages their condition, refers them to consultants, deals with any aftercare following hospital admissions, sees them for repeat medical checks. Some of this work may well be done by practice nurses or health visitors, but the GP has ultimate responsibility. For those claimants who are disabled rather than sick, the GP is still likely to know them well. Why on earth weren't GPs given the responsibility of assessing claimants to determine what work they could do?

Could it be that our Government doesn't trust GPs to assess claimants accurately? Oh dear. Not a great endorsement of our medical system.

Or could it be that the aim of the Government in outsourcing ESA and DLA claim assessments was not to ensure that those who really are sick and disabled get the money they need to live on, but to eliminate as many claims as possible to reduce the bills and keep Daily Mail readers happy?

A look at the ATOS website (occupational health section) is informative. Yes, they are involved in healthcare assessments for private companies too, so they are obviously experienced in this area. But these assessments are aimed at keeping workforces healthy, reducing absence due to sickness and facilitating rehabilitation back to work. Well, well. It couldn't be that this is what attracted the Government, could it?

Helping people back to work is a reasonable thing to do. But the way they are going about it doesn't make any sense. How can a tick-box assessment by a doctor, nurse or physiotherapist who has never met the claimant before be a better judgement of someone's fitness to work than a GP's report?

The Work Capability Assessment process conducted by ATOS has been seriously criticised by the Parliamentary Select Committee on Work and Pensions. Maybe it's time to replace it with something that really works for both claimants and Government?

Wednesday, 24 August 2011

Lessons for GFC2 from GFC1

The other day I read the National Audit Office's analysis of the events in the run-up to the nationalisation of Northern Rock. For a Government publication it's surprisingly readable and I strongly recommend it.

You may think this is ancient history. After all, Northern Rock collapsed over four years ago now. But I think there are still lessons to be learned from this and changes that need to be made to the way the Treasury does things. We still have not devised a method of managing bank failure that does not leave ordinary people - bank customers and taxpayers - on the hook for debts incurred by irresponsible bank management. And the banking sector is still desperately fragile. We urgently need a satisfactory way of dealing with banking collapse.

Lesson no. 1: The importance of planning
Northern Rock was the first of the major bank bailouts in the United Kingdom. It is very evident from the NAO's report that neither the Treasury nor the Bank of England were remotely prepared for this. The Bank of England at that time had no facility for extending emergency funding to banks suffering from lack of liquidity - which was initially all that was affecting Northern Rock. It had to get explicit permission from the Treasury to lend the money.  And handling of the media was inept. Why on earth was the emergency loan disclosed to the public? They didn't need to know, and all it did was cause panic. The run on the bank was a direct consequence of the disclosure of that loan to the public.

Once the run on the bank began it was evident that the Treasury had no idea how to deal with it. Their kneejerk reaction was to guarantee all bank deposits - including, eventually, wholesale deposits that should NEVER be subject to taxpayer guarantee.  The NAO's report makes it clear that the Treasury were winging it throughout, making decisions on the fly. Yet it appears that both the Treasury and the Bank of England had in fact been modelling disaster scenarios and considering emergency measures during the 6 months before the run on Northern Rock. But they hadn't put any of those measures in place. The necessary legislation to provide a stable rescue procedure for failing banks wasn't put in place until February 2009.

The lack of disaster planning for a business sector as key to the economy as banking was, and is, in my view negligent. Even now, we only have a legislated procedure for failure of individual banks. We have no plan for dealing with catastrophic collapse of the entire banking sector. Yet that is almost certainly what we face.

Lesson no. 2: Claim on your insurance!

One thing that struck me in the NAO's report was the fact that the Treasury appears to have totally ignored the existence of the Financial Services Compensation Scheme (FSCS), which already protected most deposits up to £50,000 (now extended to £85,000). This scheme was set up to protect savers and depositors following the near-collapse of Lloyds of London in 2000. Why did the Treasury choose to guarantee deposits and nationalise Northern Rock instead of informing depositors about the existence of this scheme and allowing Northern Rock to go into administration so that they could claim? Even now, bank depositors don't seem to know about the existence of this scheme. Banks don't tell them, and neither does the Government. What on earth is the point of having deposit insurance if no-one knows about it?

FSCS rules do say that a company must have ceased to trade in order for compensation to be paid. And the timescale is not immediate. But Northern Rock was not a clearing bank, so there was no risk to essential payments. What on earth was the tearing hurry in making funds available to depositors?  And if there were people who would suffer from not having deposit account funds available to them for months, why couldn't emergency lines of credit for those individuals have been arranged with other banks to cover them for that period?  If anyone has an answer to this, please let me know. It looks like a glaring omission to me.

Lesson no. 3: Stop the rot

The nationalisation of Northern Rock, and its separation into "good bank" and "bad bank" didn't happen straight away. During the time between its initial request for emergency funding and its nationalisation, Northern Rock received several infusions of taxpayers' money. But it carried on making bad loans during that period. The NAO's figures for the performance of TOGETHER loans are damning. Why on earth was Northern Rock allowed to continue making these loans? In fact, why did it continue lending at all? Surely if a retail bank is in sufficient difficulty to require continual funding transfusions, the first thing to do must be to stop it lending. After all, the main reason it requires funding is to settle lending.

The other reason it requires funding is to settle deposit withdrawals. I have already commented about Northern Rock's inept handling of its request for emergency funding. But would someone please explain to me why it didn't simply close its doors when the run began? Any commercial organisation can shut up shop for a day or two if it wants to. Of course, there may be some legal restriction specifically for banks that means they don't have this option available to them. If there is then for goodness'sake get rid of it. Banks must be able to close their doors.

I know that both of these measures - temporary closure and cancelling new lending - would have caused a massive loss of consumer confidence. But if depositors want to remove their money they should be allowed to - and if the bank goes down as a consequence, well, tough, really. All the closure should do is buy time for funding to be provided to meet depositors' demands.  And Northern Rock's funding problems concealed a much deeper issue. It was very highly leveraged and a growing proportion of its assets were highly risky or actually in default. Why the FSA ever let it get into this state is a mystery, but allowing it to continue lending once this had come to light was ridiculous. Cancelling offers of new lending would have been tough for people trying to buy houses, but as a lot of this lending was to people who couldn't really afford it and for far more than houses were worth, it would have been better for them in the long run.

Lesson no. 4: Who is more important - depositors or taxpayers?

Once it became apparent that Northern Rock was not viable, the Treasury considered various options which are detailed in the report. The main driver behind the decision to nationalise appears to be the belief that depositors couldn't wait for their money. I've already commented on that above, so I won't address it again here. However, given that belief, the Treasury's analysis was reasonable and full nationalisation was indeed the best option for Northern Rock and its depositors. I question though whether it was the best option for taxpayers - and this question becomes even more serious when we look at the part nationalisations of RBS and Lloyds TSB.

For nationalised companies, the validity of the Treasury's assumptions about value to taxpayers depends on the market value of the company.  This is unrealised, of course, until the company is sold or floated. At present banking shares are taking a beating: both RBS and Lloyds TSB shares are trading at well below their nationalisation value. If sold now both banks would deliver a loss to taxpayers. Recently the Chancellor actually proposed selling the "good" part of Northern Rock - which is currently making a loss. There is no way that this sale in the current climate would generate any kind of decent return for taxpayers.  So at present the Treasury's assumptions about "best value" for taxpayers look very dodgy indeed. Nationalisation may prove to be a simply rotten deal for taxpayers.

Although the Treasury believed it was acting in the best interests of both depositors and taxpayers, therefore, in fact it placed the interests of depositors (and other creditors) ahead of the interests of taxpayers. This principle has applied in all the bailouts of banks worldwide. But is it reasonable? Should depositors (and other creditors) really be regarded as more important than taxpayers?

I don't think so. In fact I think this is a simply dreadful attitude. You see, taxes are paid by people who can't afford to save, as well as those who can. So in nationalising banks, the Government put the taxes paid by the poorest at risk. In effect, those who are too poor to save protected the savings of those who could afford to save.  Nationalisation of banks to protect depositors (and other creditors) is therefore an INCREDIBLY regressive action. I am astounded that anyone on the Left regards this as a good thing to do.

Lesson 5: What do we REALLY need to protect?

From everything I have seen and read so far, the nationalisations of Northern Rock and Bradford & Bingley were driven by a misguided belief that depositors must be protected at all costs. I don't agree with this, and therefore I believe these nationalisations were both unnecessary and harmful to taxpayers.

But in the case of Lloyds TSB and RBS, current accounts were also at risk - and these are the lifeblood of our economy. Just about everyone in society has a current account now, even the very poorest. These are the accounts from which essential bills are paid and food is bought, and into which wages are paid. If people can't access their current accounts, they suffer - and the poorest people suffer the most, since they seldom have funds in other accounts. Protection of these accounts is therefore essential. But that's no reason to protect deposit accounts as well.

The problem is that in the banking world, all forms of bank deposits including current accounts are "at risk". You may not think your wages are lent to the bank when they are paid into your current account, but they are. And banks can lose that money through risky activity - particularly excessive lending, which is what caused the failure of Northern Rock, Bradford & Bingley and HBOS (Lloyds TSB). I believe this is wrong. I think that current account balances should be regarded as in safe custody and not available to banks for lending or speculation. And it is sensible in my view for government to guarantee current account balances up to a reasonable limit. Obviously if banks can't use current account balances for lending or speculation they won't make any money on them, so there would be no interest paid on current accounts and there may be fees. But the interest paid on current accounts is pathetic, and we are already beginning to see fee-based current accounts anyway.

So current accounts should be protected. But interest-bearing deposit accounts are a different matter. The FSCS is effectively backstopped by the taxpayer, and has the additional problem that it is funded by a levy on all financial institutions, which means that "good" institutions end up bailing out "bad". I would rather people understood that money placed in interest-bearing accounts is AT RISK, not in safe custody. If they want their money to be safe, safe custody could be made available - for a fee, and no interest would be paid on it. If they want interest then they either need to accept the risk that they will lose their investment, or pay for insurance to protect it. I am sure that private sector insurers would be very happy to offer voluntary insurance to those prepared to pay a premium to protect their cash....with protection against mis-selling, of course. This is how I think deposit-taking should operate in the future.

However, we have a banking crisis approaching in which large amounts of very dodgy debt will put everyone's money at risk. It is all very well saying that ideally people should manage their own risks and abandon banks they regard as taking unacceptable risks with their money. But that's in the future. The present situation is that savers - of all kinds - need protection from the approaching crisis. FSCS is essential, with backstop and if necessary top-up from government. By using FSCS, with additional emergency credit and if necessary payments facilities from the Bank of England, we can ensure that PEOPLE are protected in the coming storm, not the banks that need to be allowed to fail. For that was what went wrong in the first financial crisis. Instead of compensating depositors directly, government supported failing banks such as Northern Rock.

 Lesson 6: What if it all goes pear shaped?

I don't know if the Treasury has done any planning for the possibility that the entire banking system may collapse. I hope it has. Because mass nationalisation of banks would be appalling for taxpayers. Not only would taxpayers end up owning a wonderful collection of zombie banks with no guarantee that they would ever come to life again, but they would also own all their assets. And if the banks collapse en masse due to, for example, sovereign debt defaults, quite a high proportion of these assets will be either highly risky or actually in default. Northern Rock on a simply gigantic scale.

There is a cautionary tale here. Ireland bailed out its entire banking sector when the property construction bubble burst. In so doing it bankrupted the country, destroyed the future of an entire generation and reduced its population to penury. It is now massively in debt and its banks are worthless. Do we want to go there? Surely not!

Let's develop plans NOW to allow all banks - including retail and clearing banks - to fail safely, while protecting taxpayers, current account holders and savers from the consequences. And let's work towards a more responsible attitude to lending by banks, creditors and depositors (who of course are also lenders). That way we may survive the coming banking crisis with our economy intact.

Monday, 22 August 2011

Debate with me, don't silence me

Yesterday someone unfollowed me on Twitter. Well, this is no big deal, really - it happens all the time, and indeed the constant dynamic of following & unfollowing is one of the things that makes Twitter fun. But this one was different.

I was debating with someone who disagreed with something I wrote in my last blog. But instead of engaging with the argument, he complained that I didn't know what I was talking about, that I was "losing touch with reality", and finally sent me a direct message that he was dropping out of the argument. When I tried to reply to that message Twitter informed me that he was no longer following me.

Quite apart from the personal distress that this caused me, I find this behaviour very worrying. This is a person who influences people's thinking: he is a frequent writer and broadcaster, and has a considerable following on social media. And I am by no means the first person that he has unfollowed because of disagreement over politics or economics. If he will not debate, and will only engage with people who agree with him on these matters, then his influence is partisan. But the ability to debate, to disagree and in the end to agree to differ while remaining on good terms, is essential to the working of a mature democracy.

It is not only immature to close down debate because your opponents don't agree with you. It is dangerous. That's what happens in police states. You may think that unfollowing someone on twitter because you don't like their politics is hardly equivalent to banning political opposition and imprisoning those who don't agree with you. But it's the same mindset. The effect is to close down debate and silence your opponents.

I don't want to live in a society in which the only way to be heard is to agree with the prevailing view. It is the rich diversity of views that makes our society dynamic and interesting. And we all have the right to express our opinions, however extreme they may be, without being insulted or silenced. I hope this individual, and others like him, never get anywhere near political power. Heaven help us if they do.

Saturday, 20 August 2011

Managing Collapse

                      "Ah love, could thou and I with Fate conspire
                       To grasp this sorry scheme of things entire,
                       Would we not shatter it to bits, and then
                        Rebuild it closer to the heart's desire?"
                                                      Fitzgerald, Rubaiyat of Omar Khayyam

It seems to me that all the activity of the last three years by banks, governments and supra-national organisations such as the IMF has been aimed at one thing only - preventing the collapse of the international financial system.  To prevent that collapse governments have wrecked their economies and sacrificed the future of an entire generation. Yet as I write, the financial system seems to be in no better shape than it was three years ago. In fact if anything it is worse.

I have been arguing for some time now that propping up failed institutions only makes matters worse. If an institution is not viable, it will fail eventually whatever steps are taken to prop it up. The problem is that when it does fail, it brings a lot of others down with it. The larger and more interconnected the failing institutions, the greater the risk they pose to the world economy - and the louder the cries of people who depend on those institutions that governments should act to prevent their failure.

If the international financial system is so fragile that it can only survive with constant infusion of mammoth amounts of public money, then IT IS ALREADY IN A STATE OF COLLAPSE. And as any mining engineer knows, propping it up is not only expensive, it is dangerous.

I would like to suggest that the international financial system should be ALLOWED to collapse. That doesn't mean that governments should abandon their responsibility to protect the people affected and as far as possible prevent long-term damage to the economy. On the contrary, governments should be actively involved in managing the collapse of the current unsustainable system and the building of a new system that meets our needs better.

But that requires a mindset change on the part of global leadership, and particularly central banks and the IMF. At present they think only of maintaining the status quo. And while they continue to think and behave only in terms of keeping the ship afloat, the greater the risk to the world economy. When the inevitable collapse happens, they will not be prepared for it and the world economy could indeed suffer serious damage. But that's not necessary. Planning for and managing the inevitable demise of an outmoded form of banking has to be the best way forward.

Why do I say it is outmoded? Consider this.

1. The lifeblood of our economy is payments. But there is no particular reason why payments should be made only via banks. Mobile phone companies have the technology to perform electronic funds transfers and are beginning to do so in a limited way. As we move away from paper-based transactions such as cheques, the need for back-office banking diminishes and the front end increasingly becomes electronic.  And even paper-based transactions don't have to be handled by banks, anyway. A friend of mine runs an independent cheque processing company. At present the actual payments side can only be done through a clearing bank, but why shouldn't his company have direct access to BACS, CHAPS and the like?

2. The other key financial component of our economy is lending. Without bank lending, nothing moves. Banks have a complete stranglehold on the economy because they alone create the money that we use to buy goods and services. And because our economy is so dependent on bank lending it is prone to credit bubbles and credit crunches. When banks are feeling good about things, they lend - far too much, at too low a rate to the wrong people. The result is a credit bubble.  Credit bubbles cause overspending in the economy, consequent overproduction (or importing) and eventually inflation.  Then banks realise they have overstretched themselves - some of them get into trouble and have to be bailed out by governments - so they stop lending to ANYONE except those who don't need it. The result is a credit crunch. Credit crunches cause rapid deflation and recession. All of it is caused by the propensity of banks to over-lend in good times and under-lend in bad times. And in the background are governments which have no real control of their economies. Do we really want our lives controlled by banks? Surely there must be ways in which people and companies can borrow the money they need without messing up the economy?

3. But, people argue, banks can't possibly over-lend because they only lend out an agreed multiple of what they receive in deposits, don't they? Wrong. Banks don't actually need deposits in order to lend, so they don't seek to attract them and they don't offer a good deal to savers. Banks can obtain the money they need to settle lending by borrowing from other banks (particularly investment banks), issuing securities or borrowing from the central bank. Deposits are an optional extra. So the whole premise of "fractional reserve banking", that banks lend out a multiple of the deposits they receive, is fundamentally wrong. Modern bank lending doesn't rely on deposits at all. Which is just as well, because....

4. Bank deposit and savings accounts no longer hold people's life savings. Most savings are invested through managed funds in the investment banking sector. Retail banks simply act as a "front end" for selling those products to the customer. Yes, people still deposit funds in bank accounts, but generally those are EXCESS savings which people put aside for a short period of time and draw down as and when needed. The level of savings in bank accounts, as opposed to pensions, endowments and other forms of long-term investment, has dropped catastrophically since the 1960s. Loan to deposit ratios in retail banks are at an all time low. Do we really need traditional bank deposit accounts at all, any more? And if we do, how do we make them sufficiently important to banks for banks to offer a decent rate of return?

5. Conversely, the investment banking sector is awash with funds - and contrary to popular opinion these are NOT provided by retail depositors but largely by pension and endowment investors.  The volumes traded on international financial markets are HUGE and the frequency of trading is approaching warp speed.  No longer are investors buying newly-issued securities and holding them long-term, generating returns from coupon payments and dividends. No, these days it's all about short-term returns. The "search for yield" - higher and higher rates of return for investors - was the key driver of Wall Street's excessive risk taking in the run-up to the global financial crisis. Very little of this activity gives real benefit to people through economic growth or decent returns on their investment: most of the return ends up in the pockets of the very rich.

6. There is a toxic link between retail lending and financial markets. Securitization allows over-extended retail banks to move loans they have already made off their balance sheets so that they can lend some more. They do this by packaging those loans up as securities and selling them on into the international financial marketplace. This would be fine if the risk of those loans was low. But it isn't. Securitization is routinely used in Japan and the US to remove non-performing loans from bank balance sheets. The reason these loans are non-performing is because the debtor is in trouble. They are risky by definition. Additionally, there is evidence that securitization encourages riskier lending. After all, if you can get rid of the loans, you don't have to worry about the risk, do you? But when sufficient numbers of securitized loans go bad, the result is DISASTROUS. The Global Financial Crisis of 2008 was primarily caused by failure of securitized retail loans.

I do want to make it clear that securitization itself is NOT the problem. Indeed, because capital markets are better able to price and manage risk than retail lenders, judicious use of securitization can enable lending to groups that otherwise might struggle to obtain finance. The problem is the moral hazard that that creates for lenders, and the fact that when lending is securitized large amounts of high-risk lending endangers the global financial system. I have written on this in another place.  

7. And finally, there are practices in the investment banking sector that would be illegal if done anywhere else - insuring assets you don't own, pledging someone else's property as collateral for lending, ponzi schemes, mispricing and mis-selling. Complex maths and big words are used to hide the reality of what is really going on. If an investment banking practice or product is described in words of more than three syllables or priced using formulae containing Greek letters it's almost certainly dodgy.

I could go on to discuss the role of big banks in money laundering and international crime, the various scams that banks have inflicted on their customers (PPI, for example), the price fixing and cosy cartels, the advertising doublespeak that convinces people they are getting a good deal when they are really being scammed. But you've probably heard enough already. Do we REALLY want to preserve this? It's rotten to the core. Wouldn't we do better to allow the whole thing to implode? It is no longer working in the best interests of its customers - it is entirely self-serving, rapacious and greedy, bleeding people, companies and countries dry while it becomes ever more bloated and its main protagonists ever richer.

But how to manage the collapse of this monstrosity? First, we must stop feeding it. Ideally there should be NO MORE injections of public money. At present we are hearing demands for governments to provide liquidity (cash), increase bank capital (shares), and provide funds to countries to enable them to meet debt interest and refinancing obligations to banks. I agree that in order to manage collapse in such a way as to create a soft landing, it will probably be necessary to continue to provide some funding in the short-term. But the aim should be to withdraw all public financial support from the banking system, and it should be made clear to banks that if they get into difficulties because of the withdrawal of public funding - including debt payments - they will not be bailed out. 

Secondly, there should be a programme of debt forgiveness for countries that have got themselves into serious trouble. Playing the blame game ("it's their fault, so they should suffer") doesn't help the people of those countries to rebuild their lives and revitalise their economies - which in the end is MUCH more important than paying off banks.  Banks can and should take the hit for their irresponsible lending. After all, they received the returns on that lending in the good times.

Thirdly, it should be made plain to people and banks that deposit insurance is for PEOPLE not banks. Government should put in place through existing insurance schemes (and possibly new private insurance) measures to ensure that people's life savings, especially their pensions, are ADEQUATELY covered. And government should have ready emergency measures to enable payments to continue to be made in the event of failure of a major clearing bank, and to provide short-term financial support to people and companies whose money is temporarily inaccessible. Failing banks should go through a form of financial administration in which assets are sold and creditors paid off with the proceeds as far as possible. And if all our banks end up in landfill - well, we need replacements, don't we?

I don't think we need to worry about what would replace the present system. There are already businesses waiting in the wings for an opportunity to enter the financial marketplace - as this blog from Simon Cooke describes - who are being denied that opportunity by the dominance of the dinosaur banks. For the moment the dinosaurs are being kept alive by more and more artificial intervention to preserve their habitat. But when the asteroid of public debt default finally hits the dinosaurs will be wiped out, and a new breed of financial institutions will take their place.  And this is what goverments should be planning for, not preservation of a corrupt and outdated system. The economic adjustment will be painful, and it is the job of government to protect the people who will be hurt and support the development of new forms of banking. But the result should be a more efficient, more stable and more effective financial system. It would be well worth it.

Friday, 5 August 2011

Black Thursday

As I write, it is four in the morning and I am watching the Asian stock markets falling. Yesterday both the FTSE100 and the Dow Jones crashed, and further falls are expected today. No-one seems to have any real idea why stock markets are collapsing around the world. But on one thing everyone is agreed - we have a worldwide financial crisis. Global Financial Crisis Two (GFC2) has landed.

The seeds of this crisis were sown in the Global Financial Crisis of 2008 (GFC1). In fact you could say that that crisis never really ended, it just calmed down for a while. We have been in the eye of the storm, but now the winds are lashing us again.

The reason why it has all blown up again is very clear. We didn't actually fix the problems that caused the 2008 GFC. All we did was move the problems to countries instead. Which makes things worse.

In 2008 many major banks, and one huge insurance company, failed due to assets turning out to be worthless, and massive uninsured liabilities. Other banks failed because interbank markets froze and there was, at the time, no other major source of cheap funds.  Our solution to these problems was to take the debts of these banks on to national balance sheets, and to provide more low-risk liquid assets to markets to prevent them freezing again. This was the biggest transfer of private debt to the public sector in history. Now let's be clear about what this really means: it was the transfer of INSTITUTIONAL DEBT to INDIVIDUALS.  It was not governments that bailed out the banks. It was taxpayers.

The result is that many countries that bailed out their banks are heavily indebted - yes, obviously there are assets (shares) offsetting those debts, but those are unrealised and after yesterday worth a lot less than a few days ago. Furthermore, the collapse of the banking system sparked a deep recession during which national debts around the world rose enormously as tax receipts fell and benefit payments increased. Now, it is normal for public debt to increase in a recession, and this should sort itself out once the economy starts to grow again. But our economies haven't grown, and the debt levels in many countries have become unaffordable. The result is that we now have a sovereign debt crisis. Whereas in GFC1 the failing institutions were banks, in GFC2 they are countries.

This is appalling. When a major bank fails, depositors lose money, borrowers may have loans foreclosed, and if the bank is a clearer essential payments may not be made. That's bad enough, and it is easy to see why governments believed that these problems were serious enough to warrant using taxpayers' money to prevent banks failing.  But what we now have is a thousand times worse. Bankruptcy for a country means years and years of poverty; it may mean forced asset sales, massive unemployment levels, demolition of welfare and withdrawal of benefits. It may even mean that salaries aren't paid, sometimes for years, that power and transport systems fail, and that food becomes unobtainable or unaffordable. We have seen all of these happen in various countries in the last few years, notably in sub-saharan Africa, in Latin America and in Eastern Europe. But nobody ever thought this could happen in the rich Western World.

Well, it is happening, right now. And we don't know what to do about it. The recent US debt ceiling farce arose because there is no political agreement on the best course of action to manage the US's humungous debt. The EU has come up with one scheme after another to provide funds to Greece to enable it to pay its debts, all of which have foundered on a rock called "default". Meanwhile other EU nations are also experiencing debt distress, which the EU so far has simply refused to acknowledge. The UK is standing on the sidelines looking virtuous while slipping further and further into economic decline. No-one is fooled.

There is a leadership vacuum in the Western world. Since the US debt ceiling debacle and the abject failure of all the EU's silly schemes for bailing out German and French banks Greece, not one political leader now has the credibility to take the lead and decide what to do.  Lagarde, the new IMF head, looked promising - for about five minutes: then she was tarnished by a possible corruption scandal and that was the end of her as a credible political leader for this ghastly mess.

So is it really so surprising that markets are collapsing? We have an unstable, highly indebted financial system, unstable, highly indebted corporations, and unstable, highly indebted countries. And we have no-one capable, it seems, of sorting it out.

It seems to me that we have ignored some very fundamental principles in our handling of the GFCs. The first one, for me, is that IT IS NECESSARY FOR FAILING INSTITUTIONS TO FAIL. It may seem less painful to prop them up, bail them out, throw money at them, change their management teams, load them with heaps of regulation, even break them up into smaller bits. But we've seen all this before, notably with the big nationalised industries of the 1970s. All the support they received from the taxpayer wasn't enough to stop their eventual closure. It just cost lots more and hurt lots more people.  Isn't that exactly what we are doing with our zombie banks - keeping them going at taxpayers' expense? For how long can we realistically maintain the illusion of a healthy, well-functioning banking system? It isn't anything of the kind. Without taxpayer support it would collapse. Please, let it fail. Then maybe from its ashes a new financial system will arise, which would genuinely operate as the public service it should be.

The second principle in handling the GFCs is this: PEOPLE NEED TO BE PROTECTED FROM THE CONSEQUENCES OF INSTITUTIONAL FAILURE.  And here's where we went wrong in GFC1. We confused protecting people with propping up failing institutions. Yes, if a major clearing bank fails, depositors need to be protected from losses, borrowers need to be protected from sudden foreclosure, and emergency measures are needed to ensure that essential payments can be made. But that doesn't mean the INSTITUTION should be bailed out. It should be allowed to fail.

Had the indebted banks from GFC1 been allowed to fail, the US and UK public debt levels would not be the size they are (and we wouldn't be losing shedloads on share value writedowns).  The only major expense arising from supporting people is depositor cover, and much of that was already covered by insurance anyway. Emergency arrangements could have been made with other banks to cover payments, and lending portfolios could have been resold by administrators - including, in my view, toxic assets. There's always a market, even for risky debt.

But what about Europe? The debt levels in the European periphery don't come from bank bailouts, except in the case of Ireland, which absolutely shouldn't have bailed out its banks and I for one am appalled that it did. They come from overspending. 

Well, that's true. But it is still about bank bailouts, really. None of the money that has been lent to Greece by the ECB has gone to supporting people so that they can rebuild their lives and revitalise the Greek economy. Had it done so, in the short term banks (mainly French and German ones) would take a loss, but in the longer term Greece would be able to pay them off because economic growth would give it the means to do so. But instead, the money that has been lent to Greece has gone to pay French and German banks. In other words, German and French taxpayers have bailed out their banks - again. Greece was just an intermediary, though it was asset-stripped in the process mainly so that German taxpayers didn't realise they were being scammed. Were they fooled? Maybe. But we're about to repeat the same mistakes with Portugal, Spain, Italy - and that's where the German taxpayers (I hope) dig their heels in and shout "NEIN!". No way should taxpayers be on the hook for the consequences of stupid lending by their banks. Peripheral Eurozone countries aren't going to pay their debts. Those banks' assets are toxic. Let them fail.

The way we handled GFC1 was a big disaster, and because of that we now have an even bigger disaster. Will we get this one right? It's not looking good at the moment.