We remarked before that attempts to nobble Mervyn King would soon bring other UK bank reformers out of the woodwork, and we have a confirming sighting today, via a puzzled tweet from @EconOfContempt:
Strange op-ed by Andrew Haldane in the FT. No one is really pushing the argument that he’s trying to shoot down
EoC means this FT piece; responding to the Merv crisis, BoE regulator Haldane is pushing his latest formulation of the idea that big banks need either to be broken up, or to carry a lot more capital. He’s just published a paper about this, at Nature, if you’re keen to part with $32:
In the run-up to the crisis, and in the pursuit of diversification, banks’ balance sheets and risk management systems became increasingly homogenous. For example, banks became increasingly reliant on wholesale funding on the liabilities side of the balance sheet; in structured credit on the assets side of their balance sheet; and managed the resulting risks using the same value-at-risk models. This desire for diversification was individually rational from a risk perspective. But it came at the expense of lower diversity across the system as whole, thereby increasing systemic risk.
In his paper, he uses a biological metaphor, or model, and expands on it some more in his new FT piece:
There is no evidence that failure probabilities are lower among big, complex banks than smaller ones. But even if there were, the case for big banks holding higher levels of loss-absorbing capital would not be weakened. That case rests not on the probability of large banks failing, but on their system-wide impact. What matters is not a bank’s closeness to the edge of the cliff; it is the extent of the fall. And this will depend on a bank’s size, complexity and numbers of market counterparties.
These basic principles have long been known in the study of infectious diseases. Optimal strategies for preventing disease spread focus on “super spreaders”: not those most likely to die, but those with the greatest capacity to infect counterparties. The same calculus applies to big, complex banks. These super-spreaders of the financial world have huge balance sheets and often comprise thousands of distinct legal entities. Their numbers of counterparties are often mind-boggling. When Lehman Brothers failed, it had more than 1m such relationships. These spread financial infection on a global scale.
In the new FT piece, doubtless mindful of the recent Merlin capitulation, he seems to be leaning quite a lot more towards the ‘more capital’ alternative, rather than advocating a bank break-up:
The present situation in banking is in many respects perverse. The magic of diversification, when assumed into banks’ risk models, means that large, complex banks often hold less capital than their smaller, simpler brethren. The rocket-scientists building models tell us this makes sense. But the rocket-scientists building rockets tell us it is nonsense. This error has cost the world dear. Through this year, the Financial Stability Board is leading the charge to boost loss-absorbing capital for the largest, systemically important institutions to correct this error. It is right to do so.
Disagreeing with EconomicsOfContempt about anything at all is a completely nervewracking ordeal, but it must be done sometimes. The idea Haldane is trying to shoot down is that universal banks benefit from risk diversification, and, contra EoC, this idea is not only embedded in risk models, as Haldane remarks above, but also in the thinking of many bankers (and in some criticism of the Basel accords, for that matter).
For instance, here’s Jamie Dimon’s FCIC testimony:
While some of our businesses have faced substantial headwinds over the course of the financial crisis, others have performed remarkably well. Our size and our diversity of businesses have helped us. Size matters in businesses where economies of scale can be critical to success, particularly in areas such as systems, operations, innovation and especially risk diversification. I believe our performance and the events of the last 18 months validate this.
Admittedly Lloyd Blankfein did make a more qualified pronouncement some time back:
Certain developments of recent decades, like changes in the structure of financial institutions post Glass-Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm.
But what does that mean? It strikes me as one of those concessions that just bogs down the debate. Which are we meant to care more about: frequent relatively mild events or somewhat more frequent bigger events that threaten global financial stability? Still the latter, I should think; so why bother with the nuance?
But I suppose the guy in Haldane’s sights is, most likely, Bob Diamond:
…speaking at the CBI conference in London, Diamond said: ‘There is no empirical evidence that big is bad – in fact, quite the opposite. Banks dependent on a single market or product can be a greater risk, as we saw with Northern Rock.
By contrast, the global universal banking model, which integrates retail, commercial and investment banking, is well diversified by business and geography, well diversified by clients and products. And it should carry less risk, by virtue of that diversification, if it’s well run.
Less risk implies less capital.
So what I take from@EconOfContempt’s alerting tweet is this: having steamrollered the Treasury Select Committee and the Treasury, and apparently brushed Mervyn King aside, Bob’s next date will be with Andrew Haldane.