The British don’t do shrill, but Wolf today is as close as you will ever find on the pages of the Financial Times. And the telling sign that Wolf is borderline unhinged is (aside from mentioning his fury) that his article has less of a clear structure than his comments usually do. But he nevertheless works his way up to an important point at the end of his piece, namely, that if we cannot find a way to make banks less interconnected, so that danger to one can bring the entire system to its knees, then government has to regulate them as utilities.
I also happen to believe in synchronicity, so consider the start of Wolf’s offering, “Big risks for the insurer of last resort“:
The UK government looks increasingly like a python that has swallowed a hippopotamus
I suspect Wolf doesn’t follow lurid US animal stories, but he may know nevertheless that overstuffed snakes come to bad ends:
The alligator has some foreign competition at the top of the Everglades food chain, and the results of the struggle are horror-movie messy.
A 13-foot Burmese python recently burst after it apparently tried to swallow a live, six-foot alligator whole, authorities said.
He then discusses the de facto nationalization of Lloyds and RBS (I remember the days, not so long ago, when RBS was touted as a model of retail banking. Funny, so was WaMu):
Implicitly, the UK government is guaranteeing the liabilities of the swollen UK banks. Explicitly, it seems likely to guarantee at least £600bn of toxic assets of RBS and Lloyds under its “asset protection scheme”. I am no populist. Yet when I think of the sums earned by those responsible for dumping this mess on to the UK taxpayer, even my blood boils…..
My colleague, Willem Buiter, in his magnificent blog states bluntly that: “like its American and Dutch counterparts, this toxic asset insurance scheme is without redeeming social value: it is inefficient, unfair and expensive”. Is he being too harsh? Not much.
Clearly, the biggest attraction of such a scheme, to both politicians and beneficiaries, is that its costs are removed from the public accounts.
Yves here. That’s a point we and others have made about the various US toxic assets schemes. Paulson couldn’t figure out a way (at least in the limited time he had left in office) to hide the large subsidies that would be paid to the banks through this arrangement. So Team Obama comes up with the “public private partnership” concept, which HAS to be more wasteful than propping up banks via paying over-the-market prices because an additional party, the investors, also has to be enriched.
Back to Wolf (boldface mine):
How large might these costs be? I understand that internal calculations of the International Monetary Fund suggest a fiscal cost of all UK bank support of 13 per cent of GDP, or £200bn. I suspect this is too optimistic. Certainly, together with the costs of the economic slump, an increase of well over 50 percentage points in the ratio of public sector debt to GDP is highly likely. Such are the wages of financial mania. They would be similar to the fiscal costs of a war.
Why should not more of the losses fall on creditors, other than the insured depositors? That is the question asked by many economists. It is the approach recommended by proponents of a “good bank” solution.
The big point here is that the losses against which the government is now offering such generous insurance relate strictly to bygones. If we want banks to make new loans, it makes far more sense to guarantee those, rather than bail out all those who financed the mistakes of the past. So, suggest the radicals, toxic assets should have been left with the shareholders and uninsured creditors of the old bank, who would also gain a claim on a clean new bank. Moral hazard would disappear and taxpayers would be left relatively unharmed.
The arguments against this are two: first, the possibility of a default would create a wave of panic worse than the one that followed the bankruptcy of Lehman last September; and, second, for this reason, no individual government could dare to go it alone.
Unlike Professor Buiter, I recognise that these could be valid arguments in the current circumstances. I certainly have no desire to make the slump even worse than it is. But, if so, they have compelling implications.
One is that we must create effective mechanisms for orderly bankruptcy of very large financial institutions. Indeed, this is far and away the most important lesson of the crisis.
Yves here. Wolf does not go far enough. In the US, devising a bankruptcy regime, or at least devising interim measures to make a failure less catastrophic (could certain entities and operations be parsed out?) should have been the number one priority of the Fed and Treasury after the Bear Stearns failure. Bear was the smallest independent investment bank at the time, yet was still too big to fail. Lehman, Morgan Stanley, and by some accounts, UBS and Merrill were next on the list. With so many firms in perilous shape, planning for what to do when the next one went off the rails should have been top priority. Yet amazingly, the powers that be acted as if life would of course return to normal, even though it had failed to despite increasingly aggressive interventions. Back to the article:
Another is that if large institutions are too big and interconnected to fail, precisely because they are bound to get into serious trouble together, then talk of maintaining them as “commercial” operations, as the chancellor of the exchequer does, is a sick joke. Such banks are not commercial operations; they are expensive wards of the state and must be treated as such.
The UK government has to make a decision. If it believes that costly bail-out must be piled upon ever more costly bail-out, then the banking system can never be treated as a commercial activity again: it is a regulated utility – end of story. If the government does want it to be a commercial activity, then defaults are necessary, as some now argue. Take your pick. But do not believe you can have both. The UK cannot afford it.
This observation is of fundamental importance. Here in the US we are still dancing around the dirty word nationalization, with the respectable position being that yes, the US might take banks into the government emergency room for a while, but of course, they will be made private again as soon as possible.
But Wolf is correct. If the authorities do not find a way to change the structure of the banking industry, firms will remain tightly networked, and any one can imperil the health of all, requiring a state rescue. That means they should be very highly regulated, in the classic utility model of regulated return on equity. Finance, or at least the kind that uses depositor money and takes a lot of capital, will be put clearly at the service of the public.
Now there are ways to reduce the interdependence. Setting up exchanges is one. Limiting the scope of firm’s activities is another (Glass Steagall, which separated commercial from investment banking, had that effect).
But we see neither type of measure underway, neither an effort to rework the composiiton and operation of the industry, nor to regulate it more strictly if it is to be left more or less as is. Instead, heaven and earth are being moved to prop up a broken system in place.