Martin Wolf is arguably the doyen of global economics and finance writers. His missives in the Financial Times are must-reads and the release of his new book – which automatically uploaded to my Kindle overnight when it was released – has been much anticipated.
While I haven’t had a chance to read it yet, Wolf mapped out the problems and potential solutions to global banking in a column for the FT Wednesday.
“The financial crises and the years of economic malaise that followed represent profound failures of the economy and of policy”, Wolf began. “Above all, they were failures of understanding. We have learnt much since. But we have not learnt enough to avoid a repeat of this painful experience.”
Indeed just 10 days before the 6th anniversary of the collapse of Lehman Brothers, global banking is arguably no more stable now than it was then. Certainly, as Wolf highlights, there are more rules, but that’s not always better.
The most important regulatory result of the Great Depression in the US was the Glass-Steagall Act, which ran to 37 pages. This time, the Dodd-Frank Act ran to 848 pages and requires almost 400 pieces of detailed rulemaking by regulatory agencies. The total response may amount to 30,000 pages of rulemaking
The answer is not in complexity, according to Wolf, who says that the business model of banks and bankers is to:
Employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; promise a high return on equity; link bonuses to the achievement of this return target in the short term; ensure that as few as possible of those rewards are clawed back in the event of catastrophe; and become rich. This was a wonderful model for banks. For everybody else, it was a disaster
This is exactly the business model and practices the Murray Inquiry and global regulators are highlighting with mooted increases in regulatory capital requirements for global and nationally systemically important financial institutions.
But here in Australia, the majors have been fighting back against any calls to hold more capital as Murray and others question the true cost of too big to fail for financial stability, competition and the taxpayer purse.
But Wolf has a warning for those who claim that assets, like mortgages, are low risk and that recent history is a guide. He sights and then channels a personal economic hero of mine, Hyman Minsky, who showed that:
In general, there will be a tendency to overinvest in what is seen to be relatively low risk. In the most recent case, these were assets backed by property. Such lending will seem safe so long as a general fall in property prices is ruled out. If that turns out to be untrue, the lending will suddenly emerge as risky. Unfortunately, the labelling of a particular form of activity as relatively safe makes over-lending more probable. Its relatively low level of riskiness is a self-denying prophecy: the market response will itself make it false.
Some might say Wolf has just called out Australian finance.
But it’s solution which will scare bankers, as it is as brutal as it would be effective for global finance. He says banks should not be allowed to use “risk weights” where either they or their regulator, like APRA, work out how much of the face value of an asset is actually at risk because it leads to the over-allocation of capital, as in the example above.
Rather, Wolf says banks and economies should have leverage ratios. Under such a scheme, banks would only be able to lend a certain multiple of equity capital which would now genuinely be at risk in the event of failure rather than current arrangements which have the taxpayer on the hook.
It all adds up to banks having to hold more capital and it means a lower return on equity for banks and inevitably lower dividends for shareholders.
The banks won’t like it, but at least our kids might be saved the bailout of the next monstrous banking crisis – it’s likely to only be a small one.
I’m hoping for another rainy weekend – I can’t wait to read it.