Wednesday, 6 February 2013

Electrification Will Not Prevent Future Crises

'' When the RBS failed, my predecessor Alistair Darling felt he had no option but to bail the entire thing out...Not just RBS on the high street, but the trading positions in Asia, the mortgage books in sub-prime America, the property punts in Dubai...I want to make sure that the next time a chancellor faces that decision, they have a choice. To keep the bank branches going, the cash machines operating, while letting the investment arm fail.'' George Osborne, Feb 4th 2013.

George Osborne chose JP Morgan’s international processing centre to announce his proposal to ‘electrify’ the ringfence between retail and investment arms of UK banks, giving government a reserve power to split a bank should the fence be breached. Amidst the brouhaha that followed, it is perhaps worth asking whether separation resolves many of the problems which led to the crisis anyway.

Osborne’s announcement itself was more political pantomime than theatre, overwrought with cheap symbolism and reliant upon audience participation. The backdrop bore the JP Morgan logo portraying Osborne as the brave hero, the very epitome of a man fearless of audience and setting, prepared to deliver his devastating message mano-a-mano with the bankers in the heart of their territory. The speech drew predictable ‘boos’ from the yahoos in the stage-boxes as the BBA trawled out the usual line that this would mean less lending to businesses and a diminished role for London as a financial centre; points made with such monotony that one has to wonder whether Anthony Browne has a draw string on his back.

The shock and disbelief of the industry are of course staged, but essential to the overall act. The banks need to look like they’re feeling some pain so that the British public avert their vindictive gaze, satisfied that revenge has been exacted. Similarly Osborne needs a setting which projects his own strength but doesn’t risk public embarrassment, which is why this speech took place in the polite back office lagoon of Bournemouth, not Canary Wharf among sharks who are likely to bite; all vital as the economy teeters on the brink of austerity-fuelled decline. But behind this performance, the pre and post Vickers process has been lobbied heavily by the banking industry. Key industry actors would have been aware of Osborne’s intentions. Some may even have had a role in shaping the parameters and smoothing out the rough edges (note Osborne’s speech only says government will have ‘the power’ to separate, not that it ‘will’ separate – ominous if we remember how large corporations may use their political power and influence to avoid being split). When the amendments were announced, not an eyebrow was raised on the markets: the share price of Barclays and RBS dropped only modestly and in line with the index, suggesting that much of this was anticipated anyway.

But this all raises a bigger question. Let’s suppose we had Glass Steagall not Vickers’ fence, would we be safe from another crash? My opinion is probably not.

The causes of the crisis were/are manifold: the scale of banking liabilities relative to national GDPs; the interconnectedness of banking institutions that accompany that scaling up; the complexity of many innovations which connect these institutions and thus produce system fragility; and the opacity of the accounting information which produces uncertainty at times of stress. Central to all of these problems is the over-supply of credit. The problems of the 2000s can all to a greater or lesser extent be thought of as what happens when banks discover that they can a) lend money against a secured asset without first having to take deposits and b) discover that they can readily produce or access assets against which they can borrow. That is a circuit; the cogs and wheels of the bubble machine.

Modern Monetary Theory (MMT) has something to say here. MMT implies that banks don’t gamble with existing deposits, rather they make loans (assets) first and in doing so create deposits (liabilities) as the sum lent is credited to the borrower’s current account (this is the double entry balance sheet accounting identity). Banks then finance those deposits (or liabilities) crucially after the loans have been issued (the cashflow accounting identity). During the boom years they were able to do this relatively simply through central bank reserves or the short term markets, securing their loan with their newly acquired asset. But as the crisis bit, asset quality (or perhaps more accurately the perception of asset quality) deteriorated: the AAA mortgage backed securities, the Southern European sovereign bonds, etc that had been accepted as collateral by private lenders, all of a sudden lost that particular property. The story of the crisis therefore is really a story about the shortage of good, rehypothecatable collateral and the inability of banks to finance their liabilities while their asset position deteriorates. This is why the ECB and other central banks are working so hard to reignite the interbank market by accepting more and more dross from bank balance sheets as collateral for loans in the absence of willing private counterparties, or swapping them for ‘good’ assets which are. Central banks have in no small way become ‘rehypothecators of last resort’.

From this perspective, it doesn’t really matter if investment and retail banking operations are separate. The national and global economy relies on its investment banks just as much as its retail banks. The modern economy needs institutions that finance larger businesses, arrange M&A activities, underwrite share issues and develop hedging products for multinationals. These functions will always need to be propped up by the State if the institutions that perform those functions begin to teeter. The fundamental problem therefore is not the presence or absence of a retail arm, but the scale of the liabilities and the interconnectedness of those investment banks as the speculative activities are bundled in with their more ‘functional’ activities.

The separation of wholesale and retail may have worked in the 1930s, but it is inadequate now. It matters little whether the investment banking arm of a universal bank buys mortgages off its in-house retail arm or the retail arm of another universal bank. The macro/systemic effects are the same when scale and interconnectedness come into play. Here at CRESC Towers we are reminded of Moliere’s quip that nearly all men die of their remedies and not of their illnesses. One can’t help feeling that Osborne’s pantomime toughness and unwillingness to tackle this primary problem of scale and interconnectedness at the wholesale level, may just provide the diversion that banks need to continue business as usual.