Guest Post: Bank Reform

Guest post by Arthur Doohan: The 'battered can' that is the Irish economy has been very firmly kicked as far down the road as anyone could possibly imagine the road extending. We have imposed on the next two generations an interest only mortgage payable in 35 years time. It is a fabulous piece of financial 'legerdemain' from a country which during the boom times couldn't borrow money for 25 years!

Loudest amongst the voices 'spinning' and 'shilling' for the deal were those who said that growth and inflation will erode the many billions down to a mere bagatelle.

There was absolutely no guidance given, from people who have screwed up their growth forecasts for the last three years running, as to where 40 years of continuous growth was likely to come from.

Growth comes principally from small businesses. Many of these fail, some do moderately well and some do spectacularly well, generating through 'creative destruction' economic and cultural transformations such as that achieved by Apple.

Small businesses need credit. Credit that they are currently not getting from Ireland's pillar banks.

Ireland's banks have not been 'reformed'. Minister Noonan took various bits of dead banks and cobbled together 2 Frankenstein-ian monsters that are part zombie and part vampire. The zombie part can be seen in the inability to do anything new or to think for themselves. The vampire part can be seen in the suffering of families in negative equity mortgages.

Can banks be reformed? Can anything be done to prevent a re-occurance of a lending boom? Are we stuck with 'Too Big Too Fail' and all the real 'moral hazard' that entails, which is, of course, globally much worse now than before the crisis erupted.

I believe that there is a lot that can be done, without requiring much capital, that would give us safer, simpler and more effective banking. Sadly, none of these suggestions are those being promoted abroad by Messrs Vickers and Volcker.

The recipe is quite simple. Take out the systemic risk from 'clearing banks', make banks smaller and simpler and tweak both 'capital requirements' and 'deposit guarantees' so that they penalize gigantism and speculation.

Financial theory and corporate practice and investor preference has turned away from 'conglomerates' but that is what 'Universal Banks' are. Given the linkages across the whole economy and multipliers inherent in finance, then banks should be actively prevented from running multiple financial operations under a single capital/shareholder structure. An example of a practical implementation of this would mean no creditcard operations alongside deposit taking/lending amongst other divestitures.

On a different tack, 'UB' has a strategic weakness that imperils the whole economy and that is not found anywhere else in finance, is abhorred in the 'real' economy and for which banks are unable to advance a rationale. In equity markets, in futures markets, in commodities markets, and elsewhere, we have exchanges for the transmission of risk. In the real world we separate out energy transmission from generation and we separate making drugs from prescribing drugs.

Why do we allow banks, which advance credit, to have ownership and control of the transmission of credit/liquidity/cash. This is an historical accident whose time of tolerance has passed. From 'This sucker could go down' to 'your ATM's will shut', the loss of the 'clearing system' has been used to frighten the citizens into propping up bankrupt banks.

If the clearing system is so vital why do we allow those who pose the greatest risk to it to be its owners and operators. The existence of the other exchanges and of SWIFT show that it is not a requirement of financial markets.

So, lets strip out the 'network', turn it into a 'utility' and pay an annual dividend based on usage out of the resulting 'seignorage'.

The banks will still get a 'big slice of this action' but they will be specialists in what they should know best; risk diversification for those from whom they borrow money through prudent diversified lending.

The whole economy will then be a more secure and stable business environment. It will have at least 2 independent and near universal payment mechanisms ( clearing and credit cards) with PostOffice/Govt 'giros' a possible third (which should be strengthened/expanded).

Most nations have a 'TBTF' problem that the crisis responses have made worse through further concentration. For most economies we need to return to the 1990 numbers of independent banks and either legal or fiscal barriers put in place to prevent a reoccurrence of 'TBTF'. Andrew Haldane of the Bank of England has proved that there are no economies of scale for mega banks so let us get rid of these 'dinosaurs' before they trample us all into penury.


The rule should be that there should be enough banks with enough capital to fully absorb the loss of 1 bank without the others falling below the prescribe capital ratio. Therefore an economy with a 10% fractional reserve rule should have 10 banks operating at 11%. The rule implies that the larger the number of banks the lower fractional reserve allowed and vice versa, which provides a nice competitive pressure against 'TBTF'.

Many will say that this will make banking expensive to which the only response can be "Do you like the current consequences and costs of cheap banking?".

Who is the most important person in a bank? Yes, that's right; it's the depositor, that tender flower who needs a government guarantee before they can be persuaded to part with their money.

The primary function of a bank is to return to the depositor the whole sum of their money plus the promised interest.

The person who lends to the bank so that the bank may on-lend the money does so because they believe that the failure rate of bank loans will be small enough and profits of the successful loans will be big enough to deliver on that promise and perhaps leave a fair return for the bank's shareholders.

The calamitous history of banking means that depositors cannot now be persuaded to part with their mattress stuffing in the absence of a government guarantee. The fact that any such guarantee would have to be met by the "nearly perfectly congruent with the depositors" set of people known as taxpaying citizens is a deliciously vicious irony that until now was hidden from the perception of the underwriters i.e. the citizen/taxpayer/depositor.

This timidity has turned out to be the greatest single source of 'moral hazard' and expense in the world of finance. In the case of Iceland, her citizens refused to be taken for the ride by external risk takers speculating on non-domiciled assets. In the case of Ireland, her citizens proved to be the ultimate 'patsies' who seem content to pay for their politician's mistakes, the politician's developer friend's mistakes and the mistakes of foreign bond fund managers.

The action of the Irish Government in giving a 'blanket guarantee' was the equivalent of being the first to whip out a knife in a fist fight. It required other small states and then practically all states to do the same and only raised the chances of someone getting seriously hurt. It is probably only fair that it turns out to have been the Irish who turned out to be the 'hurt one'.

We can see clearly now that we all want to live in 'nanny states' that protect us from our own follies despite the impossibility of this 'Ouroboros'. It remains to be seen whether these costs will be sufficient to finally break the depositors 'trust' in banking and turn us all into 'Belgian dentists'.

In the absence of governments with the moral courage and business acumen to abandon the state underwritten contingent liabilities known as 'retail deposit guarantees', what can be done to protect depositors.

They have all had a good object lesson in 'caveat emptor' but I fear that most of them and their governments are refusing to see the world in such cold terms. Otherwise why would everyone be happy to see the can still being kicked down the road.

Depositor insurance guarantees were meant to give confidence to retail small depositors so as to enhance credit availability in the economy of the State issuing the guarantee. These schemes were created in the age before globalization, before the mega-banks and before the easing of capital controls.

They can now clearly be seen as a source of 'moral hazard' in banking, perhaps the largest single source.

If we are keeping globalization and free capital movement then the situation where fundmangers in Country Y place funds with a bank in Country X who lend them for asset acquisition in Country Z is clearly anomalous. The people of X are not getting the jobs, cash-flow, properties or taxes generated by the asset in Z. Further, they have no control over the evolution of the economy in Z. Lastly, it is the antithesis of capitalism that the risktakers in Y can seek to evade the consequences of their informed, professional but un-profitable choices.

Deposit guarantees must be limited to covering exposures taken in the economy underwriting the guarantee. A simple ban on foreign lending by any bank claiming guarantees for its deposits will suffice to close this unnecessary risk. The citizens and fund managers seeking higher yields abroad must be exposed to the risks they actively choose to take. They will still be free to move their money where they want but they should not be able to expose the citizens of third party countries to the downside of risks the third party countries have no control over and no gain from. Equally, banks can choose to forego the guarantee in subsidiaries that they set up for the purpose of pursuing higher yielding gains abroad.

I am acutely aware that many bankers will howl at the notion of losing the implied hidden subsidy of the broad guarantee but "hey, life's a bitch" is the only possible answer, given the losses that have been imposed by banker negligence.

I think that gamblers should be free to gamble, speculators to speculate and savers to save. But one should not have recourse to the capital of the other.

With respect to commonly held criticisms of banking structure and practices, I would point out the primary cause of problems was ludicrous valuations on residential property in terms of ratios of price/income, debt/equity and real/reported incomes. There is always much convenience in self-serving after the event analyses. Culturally, everyone wants to avoid blame. What can now clearly be seen to have failed in the boom were things like solicitors due diligence about conveyancing and banker 'prudential lending guidelines'. This patter was echoed in many countries.

The mortgage backed securities and associated embedded derivatives have not failed functionally to a significant degree in their own right. The failures have very largely come from underlying elements such as valuation rather from intrinsic mechanics of the securities themselves. To this end, while I am critical of the manipulative practices of some of the very large institutions in predatory structuring and position-taking I do not see much advantage to abandoning these 'hammers' because the 'carpenters' have abused them in the past.

Secondly, too much has been made of the 'Volcker rule' and the 'Vickers ring-fence' as panaceas. I find the 'ring-fence' to be in-organic, un-wieldy and prone to 'interpretation'. It has already been watered down and delayed considerably and, I expect that given Her Majesty's Governments addiction to the tax take from the City, that it will be further watered down and delayed.

With respect to the Volcker Rule, the gap risk and other exposures inherent in 'plain old banks' implies customers imposing risks that neither management nor shareholders may be happy with so there exists an obligation on the part of the bankers to modulate these risks. Given the new tools and techniques available to hedge risk this can be done more efficiently than ever before. However, this is virtually indistinguishable from 'prop trading' which leaves the 'rule' open to interpretation.

As I said at the start of the article the recipe for better, safer banking is part historical norms and part 'the Tao of Unix' ('system components should do one thing well and interoperate with other parts'). The elements are as follows;
⁃ Breakup TBTF banks to more GNP proportionate size with spare capital to absorb a bank failure under the rule I proposed above.
⁃ Further break up the banks to essentially 'single line of business' entities.
⁃ Put the 'clearing system' into a public utility run as a usage-based-dividend co-operative (and build/strengthen other payment mechanisms).
⁃ Limit deposit guarantees to lending secured on assets within the domicile of the guarantor.

Putting these reforms into place would create a competitive banking industry that could not be a 'tail that wagged the dog'.

Arthur Doohan is an engineer by training, a banker by experience and a ‘Web’ consultant by choice: blog.doohan.org