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Fixing Finance

1 July 2013 By Hugo Dixon

After six years of crisis, much progress has been made in fixing the financial system. There was, for example, a landmark European Union deal last week to make creditors rather than taxpayers foot the bill for bust banks. But there’s a huge job still to do.

In the years running up to the crisis, the financial system ran amok on both sides of the Atlantic. Among the long litany of problems was a clutch of distorted incentives, which encouraged banks to take excessive risks by rewarding success but not punishing failure. These heads-I-win-tails-you-lose incentives skewed the behaviour of individuals, banks and the entire system.

A crackdown on bankers’ pay is starting to deal with individual risk-taking. Compensation can be clawed back from financiers whose bets ultimately turn sour. There are also plans, mainly in Europe, to pay a chunk of bankers’ compensation in “bail-in bonds” – which will get wiped out or turned into lowly valued shares if a bank fails. That should get bankers to pay more attention to risk.

Creditors are also being given an incentive to make sure their banks don’t run excess risks. That’s one reason last week’s EU deal requiring creditor bail-ins, not taxpayer bailouts, is so important. Creditors will pay attention too. The work isn’t complete, though, because it is highly undesirable to bail in depositors, as was done in Cyprus earlier this year. Far better to require all banks to hold a minimum amount of capital that has been specifically earmarked for bail in. That way, creditors will know what to expect upfront.

At a system-wide level, the main one-way bet was caused by Alan Greenspan’s habit (while he ran the U.S. Federal Reserve) of riding to the rescue of markets when they tumbled but doing nothing to prick emerging bubbles. There is now general agreement that central banks need to lean against the credit cycle – not just by raising interest rates but also by requiring banks to hold more capital when credit is flowing too freely (something which is not, admittedly, a problem at present).

The old rules of the game didn’t just encourage one-way bets. They also incentivised banks, companies and, in some cases, individuals to take on too much debt. Here the main culprit is the widespread practice of allowing companies to deduct interest payments before calculating the profit that should be taxed. Unfortunately, hardly anybody is attempting to reform this massive distortion.

Then there was a batch of problems connected with how banks were regulated: lenders were required to hold too little capital as a cushion in case their loans went bad; they were allowed to finance themselves too much with hot money, which ran away at the first sign of trouble leaving them high and dry; and they were allowed to be so mind-numbingly complex that nobody, even their managers, could understand them.

Again, there has been some progress. Banks are being required to have fatter capital cushions – with the biggest ones having even fatter cushions because of the chaos they’d cause if they failed. But the system for calculating how much capital is required is flawed. Different types of loans are weighted according to riskiness, which is good. But banks have a lot of freedom to decide these risk weights themselves, which makes a mockery of the system.

Banks are also being weaned off hot money. For example, one feature of last week’s EU deal is a requirement for banks to pay into industry-wide bailout funds. The amount they pay will depend on the riskiness of their funding structures.

Moves are even afoot to cut banks’ complexity. Here the most promising initiative is the requirement for banks to write “living wills” – which will determine how they can be packed off to the knacker’s yard if they get into trouble without creating havoc in the financial system.

Such living wills could start a healthy dialogue between banks and their regulators over how to restructure lenders so they are less complex. The initial versions of the wills won’t be fit for purpose. But if regulators are tough enough to keep sending them back until they are workable, much good can be done.

The final problems are mainly, though not exclusively, related to the euro zone. Here inadequate progress has been made to force zombie banks to face their problems, with the result that they are suffocating the economy. Meanwhile, the financial system is too dependent on banks rather than capital markets for channelling funds from savers to investment.

There is finally a glimmer of hope that the European Central Bank will force a proper cleanup of euro zone banks in advance of taking responsibility in mid-2014 for supervising them. It is virtually criminal that this was not done on 2009 when the United States did its cleanup – a failure which is partly responsible for the agonisingly long euro crisis. Still, better late than never.

Unfortunately, little has yet been done to build healthy European capital markets. Indeed, some ideas to emerge from Brussels – such as a financial transactions tax and a plan to cap fund managers’ bonuses – seem more designed to throttle markets than encourage them.

After six years of crisis, it is extraordinary that the job of fixing finance is not complete. But policymakers must not stop until they finish the job.

 

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