Meryvn King Calls for Structural Overhaul to Banking Industry

Mervyn King, the governor of the Bank of England, gets it. Why does he have so little company on this side of the pond?

King discussed what it would take to fix the financial services industry, and it’s more ambitious than anything you see under consideration in the US. Per the Independent:

The Governor said he advocated a “three-legged stool” approach to shake up the industry. This would consist of raising capital requirements, the creation of living wills for winding up banks if they fail, and an overhaul of the industry’s structure…

Changes would not occur overnight, he warned. “Whatever the pros and cons of various alternatives, the system that has the least going for it is the present system. That’s the one that has brought us financial crisis of ever-growing severity. That’s why asking radical questions about the structure is the right way to conduct the debate.”

The structure was crucial because “from time to time things will happen that we can’t prevent or imagine or calibrate the risk of in advance”, Mr King said. “When it happens, the right thing is not to pretend in advance you can stop it from happening but to design a system that is resilient enough, so that when it still happens one part of the sector doesn’t bring down the other.”

Those who have read Richard Bookstaber’s Demon of Our Own Design will recognize that King is in effect calling for the system to be less tightly coupled. In system dynamics terms, the financial system now is tightly coupled, meaning when a process is initiated, it moves in a sequence that cannot readily be interrupted. Risk mitigation efforts in tightly coupled systems often backfire, since the overly tight integration means any itervention is likely to produce unexpected, typically unwelcome, outcomes.

What frustrates me is that so many who speak of reforming banking in the US keep thinking in terms of traditional banks which take deposits and make loans. Traditional banks were not the epicenter of the crisis, and focusing on them, as opposed to capital market, will lead to incomplete and inadequate remedies.

The big trend in banking over the last 30 years is the way in which traditional banks have been disintermediated. Banks’ share of total lending has fallen continuously during this period. Credit is now what Timothy Geithner has called “market based credit” in which loans are typically packaged up and sold to investors, rather than held by banks. For a whole host of reasons, a comparatively small number of firms dominate this activity globally. Just as the rise of personal computers took us from mainframes to distributed computing, so did the rise of securitization take us from a world of stand-alone banks to one of intermediated credit. And as “the network is the computer,” so to are “the debt markets are the banking system.” And those debt markets are in the hands of very few people who understand full well that they own infrastructure that is vital to modern commerce.

The object lesson du jour is a comment in the Financial Times by Raghuram Rajan, which sets up a lot of straw men (is being too big really the problem? Big can be good. Oh, and activity limits will be really hard! Yes, Virginia, regulating is real work. It has been so long since anyone in the US has done it well that we have forgotten what it takes). His last paragraph is particularly barmy:

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention — deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

Yves here. Where was Rajan during the crisis? Did he miss the run on Revere Fund as a result of the Lehman bankruptcy, a run that was on its way to morphing into a full blown run on ALL money market funds? The government had to step in and guarantee money market funds, remember?

And had AIG been allowed to fail, $20 billion in commercial paper would have been downgraded. The blowback to money market funds would have made the Lehman fallout look like a stroll in the park. Money market funds are also meaningful repo “lenders,” and prices on some types of paper that was widely accepted for repos also fell in the crisis.

The idea that there is any perfectly safe short term investment vehicle absent a state guarantee is ludicrous. The role of banks (and later, other vehicles have stepped into this function) is maturity transformation, aka borrowing short and lending long. If you have maturity transformation, you have the risk of bank runs, If you forbid maturity transformation, you will see very little in the way of credit (the world is uncertain, and most people like and need the flexibility of deposit-type arrangements.

Steve Waldman isn’t too happy with that paragraph either (“No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable,” for instance). Waldman instead proposes to insure depositors rather than bank, which is an interesting but as he points out, modest, idea.

But the bigger point here is that I see perilous little grappling with the problem that King flagged, that of industry structure. The idea that we can’t get from A to B is absurd; the 1933 and 1934 securities regulations represented enormous change and proved effective and durable. Do we need yet another financial system near death experience to mobilize the needed thinking and action?

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  1. David Smith

    Hi Yves,

    A question for you (or anyone else).

    Wasn’t it the case that the process of dis-intermediation you describe as it applied to deposit-taking banks involved the bundling of loans and on-selling the attached securities to investors. The structures of the MBS was such that the high risk equity tranches were retained by the issuing bank. These in time were also diced in new structured products (CDOs) etc, again sold to investors but also again leaving behind an even more toxic equity tranche. I believe these remaining securities were often hidden in repo markets. But wasn’t it also the case that they were often purchased by hedge funds? Moreover, they were hedge funds owned at arms length by the same deposit-taking banks issuing the securities? Don’t the Volker rules therefore offer the prospect of a short-circuit for this ponzi behaviour, at least amongst the deposit-taking banks? And if so, wouldn’t that also shrink the shadow banking system significantly, in turn retarding the capital market operations of investment banks?

    A penny for your thoughts.



  2. fresno dan

    “Credit is now what Timothy Geithner has called “market based credit” in which loans are typically packaged up and sold to investors, rather than held by banks”

    Well, I have been contributing to my 401k (TSP – gubermint version) – so I am a somewhat typical investor.

    “Steve Waldman isn’t too happy with that paragraph either (”No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable,” for instance.”)

    Isn’t that the truth! I (and probably most investors) really weren’t “investors” – we were buyers. I had no idea of how the shadow banking system worked – or that there was a shadow banking system. I “invested” (i.e., bought) simply because the millieu was that is what one did. If a banks “assets” are what most people call loans, and you get to make money by making more and more loans, and if a loan goes bad, someone else takes the loss, how is it NOT possible that this will end in tears???

  3. craazyman

    the willingness of these financial psycopaths to deny the obvious, torture logic, twist language and abuse mathematics for their own self-enrichment at society’s expense is more than utterly nauseating.

    They profit immensely from tightly coupled systems prone to boom bust and bailout, as their millions of financial murder victims scream in agony.

    Any fool with half a brain can understand what needs to be done to reform the system to benefit society at large, notwithstanding the rhetoric of these financial sophists.

    If there were a North and a South with militias, and a Fort Sumpter, we’d already be in a Civil War. That’s how hatefully repugnant these assholes are in their financial slaveships loaded with chink chains of deception and usury.

    They truly are possessed by demons, demons of thanatos, eat and kill, eat and kill, eat and kill, like bacteria. And when there is nothing left to eat, they will try to eat themselvs in a blind craving addiction to death.

  4. RueTheDay

    “What frustrates me is that so many who speak of reforming banking in the US keep thinking in terms of traditional banks which take deposits and make loans.”

    If Glass-Steagall were re-instated, then this is exactly what banks would do. Then, “non-bank capital market firms” would be free to gamble with their owners’ equity, but they’d have to do it without depositors’ funds or bank loans based on depositor funds.

    Re: Money market funds – The shadow banking system must be addressed. Anything that accepts deposits or creates deposit-like instruments must be declared a bank and regulated as such.

  5. scraping_by

    The Free Market is the central metaphor of the right-wing ideologues who run academic economics and the Obama Administration. Like any metaphor, as long as it’s kept in literary word games, it’s harmless. It’s when it’s applied to the real world that it turns into a lie, and in this case, a lie that kills.

    An alternative idea of banking as a public utility that concentrates excess wealth into capital (credit unions, mutual insurance, etc.) is sane, workable, and dull. No more tales from Michael Lewis about frat boy excess or ego-driven disaster. No more spare money lying around for suits in and out of government to stuff in their pockets and walk away. Just another input into the enterprise’ as the textbooks are fond of saying.

    The lie of ‘The Free Market’ prevents too many alternatives. No amount of regulation, no structural changes, no number of bankers going to jail, will prevent new and wordy variations on the carnival shell game. It’s time to remember the game is rigged, so we might as well rig it for ourselves.

  6. MrM

    Did he miss the run on Revere Fund as a result of the Lehman bankruptcy

    Yves – It was Reserve Primary Fund that broke the buck and caused the seizure of the Money Market Fund segment.

  7. Carter

    You want your cake and to eat it too!

    In one post you deride the AIG assistance as a bailout of the banks. But here you hit on a key motivation for the official sector support of AIG when you say “the blowback to the money funds would have made Lehman look like a walk in the park”.

    And let’s remember that the Reserve Fund was an institutional (not retail) MMMF.

  8. Kevin de Bruxelles

    No parasitic organism is ever going to voluntarily limit its access to the host’s lifeblood through reform. Even the weakest proposals to reform the financial structure in the US will be labelled as “class war” by Wall Street’s media hacks. The situation will most certainly have to get worse–much worse–before any real reform can begin. And that reform can only start when political power is stripped away, by the people, from the current two-party cabal of complicity and handed to real reformers. The actual policies are not rocket science; the real problem is gaining the power to affect these reforms. The current system crossed its Rubicon in October 2008 and there will be no going back until the people of the US strip the current oligarchy of power.

  9. Skippy

    Bond holders must share the pain regardless of their financial tree ascendancy…we must all share in the folly we have perpetrated.

  10. Siggy

    It occurs to me that Mr. King has it partially right. What needs to be addressed is the fundamental structure of the financial system. Then we would be talking about ‘banks’ plus the ‘shadow banking system’. Many of our problems orginated in the shadow banking system. Originate to distribute was a business plan that was followed by more than just mortgage and loan brokers. The whole securitization thing is an originate to distribute scheme.

    Banking, in the traditional sense is about money. Begin there. Is a fiat currency capable of performing the principal functions of money? Can a fiat currency genuinely serve as a store of value? With that question in hand consider the fractional reserve system that is observed by banks and deposit acceptors. The inherent risk of a fractional reseve system is obviously the demand for redemption of the deposit. If you accept that the investment of deposits has been prudent, that risk is that of illiquidity. On the other hand, if the investments made with deposits are of medium to high risk, the potential for bankruptcy is immediate.

    The foregoing considerations are the core ingredients of the stew we are in. Everything else is seasoning.

    Clearly, all of the foregoing is merely palaver that will be ignored so long as the financial community and the politicians see their best interests as lying in a return to what was. In order to break the model the electorate must send a clear message that what is wanted is equity and justice. To get to that the electorate will have to begin to vote the incumbants out, lay petitions for redress upon their representatives and boycott those institutions that insist on a return to excessive leverage and self dealing.

    Sadly, I see no personage who will assert the form of leadership that is now required. As a practical matter we are now a moderately wealthy republic that is fast becoming a banana republic and we are hastening our decline by pissing money down a rat hole in the presumption that the only course of action is to delay the liquidation of all that debt that cannot be serviced.

    To greater or lessor extent we have doing this inflate and borrow and spend now nonsense for over 40 years. There is no soft landing available. What lies before us is like chemo-therapy. Take the pain and discomfort now and maybe we’ll survive; or, delay the therapy and die a great deal sooner than we might desire.

    1. Doug Terpstra

      Great observations, Siggy, but so gloomy. “There is no soft landing available. What lies before us is like chemo-therapy. Take the pain and discomfort now and maybe we’ll survive; or, delay the therapy and die a great deal sooner than we might desire.”

      Put our affairs in order! Indeed, the minutiae of regulation doesn’t begin to resolve our fundamental predicament. James Howard Kunstler says it well on Clusterfuck Nation:

      “The underlying reality is that the financial sector of the economy has got to shrink. It ballooned from about five percent of the US economy to about 22 percent over the last two decades — mainly as a way to compensate for our declining real productive activity as we off-shored and outsourced and disassembled US industrial capacity. Capitalism only works when it operates in the service of productive activity. Trading mere paper certificates (or digital simulacra of them) in ever more “innovative” (i.e. abstract and incomprehensible) ways is not a substitute for making goods. These practices reached such a grotesque level of unreality that they eventually poisoned what remained of our economic prospects. Now that their operations have been revealed as perfidious, these institutions have to be sliced and diced and, in some cases, punished, perhaps with extinction. It will happen anyway. The only question is whether civilian leadership can guide the process within the rule of law. In the meantime, the derivatives rackets that made up so much of the fraud — especially the trillions of dollars vested in credit default swaps contracts — are ticking out there like bombs placed by madmen, and may bring down the entire global money system before an orderly downsizing of finance can occur.”

  11. i on the ball patriot

    Mervyn King should be standing on a three legged stool with a rope around his neck.

    Its not just financial structure that needs an overhaul. We need to overhaul the entire political structure. Aggregate generational corruption has rendered it — so skewed that the masses get screwed! That is job one, all else is remedial FANTASY.

    Regarding this;

    “(”No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable,” for instance)”

    That’s elite bullshit. Citizens could easily monitor a non parasitic ZERO interest utility banking system. As you said, regulation is hard work. It should also be shared work. The more eyes on the ball the better. If time is a concern monitors could be selected and paid as in jury duty. Scamericans must end this nonsensical notion that they have been propagandized into that makes them believe that all they have to do to fulfill their civic responsibility is go vote in a scam election every few years.

    Deception is the strongest political force on the planet.

  12. dave

    While it is true that sales clerks shouldn’t be responsible for investing, there comes a point where one reaches a capital level where they have to start participating in the market. That’s why makes a market work, participation. Aggregating the opinion of millions of capital holders to form prices. We prefer capital holders to make these decisions because its their money, and people always pay more attention to it if its their money. If they turn it over to an agent and don’t monitor their activity because of a guarantee then all of a sudden you’ve got a bunch of people handling “other people’s money”, and we all know that you never do as good a job with other people’s money.

    So by all means provide some guarantees on some paycheck to paycheck store clerks bank account. But once people start saving real money you need to start taking responsibility for your capital. Giving it to agents and then hoping that some government agency will keep them from gambling it away is a fools mission. No government agency is going to be able to keep millions of agents in line for long.

    1. i on the ball patriot

      Dave said – “While it is true that sales clerks shouldn’t be responsible for investing, there comes a point where one reaches a capital level where they have to start participating in the market.”

      Why? What kind of market do they “have to” start participating in? Maybe if they have so much excess capital they have simply been greedy, taken more than a fair share, and they should engage in some of that good old rich man scam “give back” bullshit like Bill Gates. Then they would only be risking a very, very, small percentage of their capital.

      Dave said – “We prefer capital holders to make these decisions because its their money, and people always pay more attention to it if its their money.”

      We like to see rich people give more because its not their money, they stole it on a crooked playing field.

      Deception is the strongest political force on the planet.

      1. Doug Terpstra

        Deception indeed: “We prefer capital holders to make these decisions because its their money, and people always pay more attention to it if it’s their money.”

        Who’s we? I’m sure Dave means well and may fully understand this junk himself. But I don’t, and the idea that craftsmen and creators who actually make useful things should be expected to entrust savings to and understand MBSs, CDOs, CDSs, SIVs, SPEs, “raptors”, “get shortys”, and various complex derivatives managed by hedgehogs like Bernie Madoff (regulated by the SEC and rated by Moodys!) is sheer madness in view of recent history. This same argument is trotted out again and again to justify privatizing (‘corporatizing’ per Nader) Social Security and for “health savings accounts”—hyped by parasitic predatory moneychangers lusting and drooling red over the massive trust fund that they have in fact already looted. Whenever the wolves try to peddle this idea to unsupecting sheep, it must be vigorously opposed.

        1. cougar_w

          The maybe the question is binary.

          Which is better behavior overall for the economy:

          1) Store clerks giving their excess earnings to someone to invest in aggregate for them, where the investor understands the markets but has nothing to lose;

          2) Store clerks putting their excess earnings in savings.


        2. dave

          The people who invested in MBSs, CDOs, etc. where agents, not capital owners. Capital owners deposited money and bought shares/bonds in institutions run by agents that were doing these things. Yes, it is the responsibility of these stakeholders to monitor their agents. If they don’t understand what their agents are doing then they shouldn’t be giving them their money. We ran into a problem because people knew the government had their back if their agents mismanaged their money.

          By all means have some banks that engage in low complexity low risk lending and insure depositors in those institutions up to a certain cap. Joe Six pack living paycheck to paycheck doesn’t have the time or expertise to either invest himself or find a suitable and reliable agent to do so. However, millionaires do, and they have a responsibility to be active monitors of their capital.

  13. i on the ball patriot

    Dave said – “Joe Six pack living paycheck to paycheck doesn’t have the time or expertise to either invest himself or find a suitable and reliable agent to do so.”

    Joe Six Pack lacks expertise, time, and capital, because he has been denied opportunity on a tilted playing field bought and paid for by greedy millionaires.

    We like to see greedy millionaires and other unfair, parasitic, gang raping people swinging from the ends of ropes.

    Deception is the strongest political force on the planet.

  14. Chris

    King is correct – removing tight coupling is the key to fixing the problem, especially tight coupling due to complex financial products that are poorly regulated and understood.

    Financial institutions can be expected to oppose this. Tight coupling benefits them because it means that losses, when they occur, are system-wide and catastrophic and can therefore easily be shifted onto the taxpayer via a government bailout. Complex products benefit them because they create arbitrage opportunities based on access to information and understanding of the models – especially if they can be dressed up to look simple and customers can be fooled into thinking they understand them. (This appears to be Goldman’s primary business activity, or at least one of them). They also provide many opportunities to increase coupling in non-obvious ways, both explicitly and implicitly by discounting risk that isn’t captured by the models (most notably systemic risk).

    TLDR: Tight coupling and complexity mean profits, and eliminating them would reduce profits.

  15. Don the libertarian Democrat

    I waited to see if anyone picked up on the fact that King is putting forward Limited Banking. Still, if anyone is interested in such a plan, they can read this book next month:

    Kotlikoff, Laurence J.
    Jimmy Stewart is Dead
    Ending the World’s Ongoing Financial Plague with Limited Purpose Banking

    Detailed description
    Discover how the global financial plague is poised to return, and what can be done to stop it

    This is not your father’s financial system. Jimmy Stewart, the trustworthy, honest banker in the movie, It’s a Wonderful Life, is dead. And so is his small-town bank, Bailey Savings & Loan. Instead, we’re watching It’s a Horrible Mess with Wall Street (aka the Vegas Strip) playing ever larger craps with our economy and our tax dollars.

    This book, written by one of the world’s most respected economist, describes in lively, humorous, simple, but also deadly serious terms the big con underlying the big game-the web of interconnected financial, political, and regulatory malfeasance that culminated in financial meltdown and brought us to our economic knees. But is also proposes a solution-Limited Purpose Banking, a straightforward and easily implemented plan to make Wall Street safe for Main Street.
    * Outlines the first and only proposal to fundamentally fix our financial disaster for good
    * Written by a leading economist whose insights on this topic are unparalleled
    * Explains the tenets of the plan, such as the regained government control of the money supply and the new role of insurance companies

    Jimmy Stewart Is Dead will fundamentally change the way you think about the economy, financial markets, and the government-sand even if you don’t agree with Kotlikoff’s conclusion, you’ll find his analysis of the crisis and his simple solution a true economic eye-opener.

  16. psychohistorian

    A couple of observations.

    The heuristics of tightly coupled systems are noisy as well and prone to wild gyrations. A purposeful design flaw in our current economy?

    Structural changes are necessary with our socio-economic bargain but cannot occur until there is catastrophic failure of the existing paradigm. It is not the processes of the system that are intrinsically bad but their organization and purpose. IMO the problem is that there is no social will to build truly public oriented (non-profit) services for health care, finance and education for starters. Access to a X-multiple of your verifiable income within the public banking system could be limited and loans beyond that could occur within the private (non-backstopped) financial system for example.

    All it takes is the social will and some leadership. What more could you want?

  17. FinanceWatcher

    It is surprising (1) that Rajan would demonstrate such an appalling ignorance of history (2) that the FT would, by publishing such crap, validate his appalling ignorance of history. Which, incidentally, seems doomed to repeat itself, if Rajan’s commentary is any indication of the level of comprehension of what caused the crisis.

  18. Richard Kline

    What we really have here is not, at base, a financial system problem, or even a system problem; what we have is a political problem. Aggregation of credit intermediation didn’t occur because it is desirable, sustainable, or inherently systemically driven: aggregation of intermediation happened because it is tremendously profitable to the aggregators—at everyone else’s expense, no value added, into the bargain.

    Now, I do believe that there are systemic vectors which do inherently drive concentration, as I’ve discussed before. This was dimly understood once on a time in the US, and there was this regulatory principle called ‘antitrust’ whose function was to buffer concentration. Antitrust has been profoundly gutted in the US. Not in the EU, as we have seen in multiple major cases over the last ten years. They still do some of that democratic socialism over there, even in Britain if late and lame to the game. Over Here, we do demonization of liberalism speak not of socialism.

    Practically speaking, the richest 1% of the US defected from their constituent society a generation ago. Inflation frightened them. Third World peoples with guns and without colonial masters terrified them (and seized ‘their’ property Over Yonder). The richest 1% broke the social contract, and set out to gut regulation or an restriction on wealth concentration &etc. And they have succeeded. They own both political parties. (Not to speak of conspiracies, just look at the _policies_ and this is an evident fact.) They own the media. They own the Executive and most of its senior decision makers with a handful of transient exceptions. All of this has been greatly abetted by a poplace bloating before the tube yukking it up watching Circus of Idols and Bombs A-Droppin on guys with dishcloths on their heads who are the ones branded enemines de jure though said watchers aren’t any too sure which side of the globe the Unpronouncables inhabit.

    We have a political problem, that the rich have broken the social contract and put themselves above any law or political compact. And we won’t fix any systemic problems in the credit provision system until we at least get a handle on that political problem. Which judging by present ‘progress’ in that regard will prove less easy and speedy of accomplishment then belling the cat. Hmm.

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