Are banks just a tax on the more useful parts of the economy?

Lord Turner the UK Financial Services Authority chairman in his speech “Reforming finance: are we being radical enough?” advocates a tough line on bank regulation. His speech is well worth reading.

He quotes a conversation he had with the late Tommaso Padoa-Schioppa, the much respected former Italian finance minister, central banker and economist who sadly died late last year. ‘The question we have not yet answered’ he said ‘was whether this was a crisis of specific institutions or a crisis of markets and systems’.

Lord Adair’s conclusion is that we must understand the banking crisis of 2007-09 as the latter.

He argues that the banking crisis should be seen as raising problems in three dimensions of reform

• How do we achieve financial stability?
• How do we and do we want to achieve greater social equality: Have we thought deeply enough about why finance has grown so large relative to the real economy, why pay in finance is so high, whether this is a problem, and if so whether we can do anything about it?
• Was this crisis, as some have argued, a crisis not just of specific institutions and regulations, nor even just a crisis of markets in general, but also of an entire economic theory? And if so has that theory been appropriately de-throned?

“We could face an unstable system even if we had perfect mechanisms for allowing banks, however large, to fail without taxpayer support. And that we could have growing inequality, driven by growing financialisation of our economy, even if all banks could fail or banks were smaller. And there is I believe some danger that an exclusive focus on the ‘too big to fail’ debate, far from being theoretically radical, can reflect a new variant of the simplistic conventional wisdom which provided the theoretical underpinning for past policy mistakes.”

There is a danger in the cerrebral approach, that by trying to do too much it achieves too little, but in essence, I think Lord Turner is right. I would go further….

The problem for the UK regulators and government is not just that this is an international problem, it is that the City of London is too important to the UK economy. Some 20% of taxation (in a good year) comes from the Financial Services Sector. It is hard to square proper regulation with the need to rebuild the nations coffers let alone address a social equality agenda or reform of the Anglo Saxon Free Market model.

John Meynard Keynes once said “owe a bank manager a thousand pounds and you are at his mercy, owe him a million and he is at yours”. We now live in an economy where the same can be said of governments.

Has banking in the early part of the 21st Century become too profitable?

Has Banking become a tax on the productive elements of the economy?

The ability to generate wealth by moving money is one thing, the management of real risk another but so much of bank activity has become speculative trading. The scale of trading is out of all proportion to the underlying economic activity. 

There is an argument that so much of global capital is tied up (or rewarding) the allocation of global capital, that the economic job of allocating resources to the most productive parts of the economy has been lost. If the most productive allocation for capital is in the task of allocating capital then there is surely something wrong with the system?

Banking has also become the creation and trading of assets the risk of which so few people understood that the institutions palming them off were lending money to the institutions holding them. Banls were acting like bad street conjourers who were taking money off the people they had placed in the audience. This is not productive risk management – it is risk obfuscation.

The tax revenues paid to the government by the financial services sector in the good years are currently seen as necessary to recovery in the public finances. Even more important to the public purse is that the share prices of the banks should recover enough to re-privatise the quasi-nationalised banks.

But are we missing an opportunity to fix something that the last time it broke almost brought down our entire system?

The ability of the banks to generate wealth will generate excessive pay to the brightest and the best (and often on the trading floor on a rising market the pure lucky) and will always create envy – but it also creates a distortion in the economy in which the brightest minds get sucked into a world with little relevence to the rest of the economy… until things go bad.

It is galling in the extreme to see Bob Diamond trying to defend the pay levels of Barclays Capital (to take just one example) – when it is plain to most people with a brain that even those institutions that (like Barclays) did not opt for tax payer equity are non the less subsidised by the taxpayer. Not only has “quantitative easing” been a way to pass a hidden subsidy to the banks by the creation of market demand, but more importantly Barclays Capital’s balance sheet is underwritten by the “too big to fail guarantee” of the UK tax payer. The “TBTFG” means that Barclays Capital gets its funds at a substantial interest rate discount and opens it to lending from institutions who rely on the implicit TBTFG. If Barclays Capital did not have the implicit TBTFG – it is unlikely that it would be as profitable. So the city traders bonus is taken for taking risks that are in fact underwritten by the taxpayer in a way once asked for but refused to successive heavy industries like Coal, Steel and Shipbuilding.

There are social cohesion arguments for nationalising retail banking and letting the “Casino Banking” operations of the retail banks spin off towards their own unsupported success or failure. Social cohesion is not yet a strong enough argument to persuade the politicians that this will be a wise move. To date they have restrained themselves to “calls for pay restraint” when as the largest shareholders in several banks they could enforce it.

It is too easy to blame the banks for the fact that both the US and the UK require debt financed consumer spending to pick up to get themselves out of a crisis caused by and over reliance on … unsustainable debt financed consumer spending. We are all to blame, but some are more culpable than others. “Can you blame us for lending money it is what we do?” Ask the banks. The lending however has been uncontrolled and to people who cannot afford it. If a farmer catches a fox in his hen house he may not blame the fox for following its instincts … but he still shoots it. 

Truth is we need debt fueled growth. Productivity alone cannot grow fast enough to pick up the slack – unless we want to spend 20 years instead of 10 repaying the debt.  We are edging our way out of recession by borrowing off the Chinese so that we can (like a drug addict borrowing off their dealer) continue to fund our Government spending and trade defecit habit of buying Chinese made imports.

 Fixing the borrowing may already be too late without a massive structural adjustment. Historically such adjustments have eventually come through currency devaluation or wars.

Given human greed, short sightedness and imperfect information Banking may always be set on a cycle of spiralling boom then bust. The problem is that historically the flows of money involved are getting bigger. It may be too late already. Banks may not just be too big to fail, but too big to regulate.

 The reality is that Governments need to control banks through regulation, liquidity and capital adequacy controls. Basel III is laughably inadequate. All it shows is that the European banks have got so woefully undercapitalised that even the most light touch regulation would cause them to become uneconomic.

The problem with the regulatory approach is that too rapid an implementation would cause a reduction in the supply of credit at a time when the recovery is fragile and risk reducing the share price of the banks the governments want to sell off to reduce their borrowing.

Something must be done to prevent recurrence of 2007/09 and it needs to be credible. One solution would be to introduce a time table for the introduction of known banking controls. Even this is problematic as the speulators in the markets will factor in the future reduction in profitability of the banking sector into the price of the shares in the currently nationalised (I am using this term loosely) banks. The probable outcome will be a political fudge. The regulators will growl, the politicians criticise and do nothing except call for a commission to investigate and recommend solutions. Time will pass. The banks will put on fat ready for the hard times ahead…. for once the big banks are sold back and recovery underway… then and only then can regulations be imposed.

As always the trick …. is in the timing.