Reforming finance

Bare-knuckle in Basel

The task of sorting out banking is far from finished

May 27th 2010 | From The Economist print edition

ANYONE who doubts how hard it is to reform finance should consider the past fortnight. In America Congress edged towards passing the biggest reform of Wall Street since the 1930s; the heart of this is a pledge that taxpayers will never again be on the hook for failing firms. On May 24th the global banking industry’s biggest lobbying group made a similar pledge. Yet at the same time borrowing costs for banks have spiked up, reflecting fears that southern Europe’s woes might bring a big bank down. The response of investors and supervisors has not been joy at this reassertion of market discipline. It has been dry-mouthed terror, and, one suspects, a familiar thought: what can the state and central banks do to help?

The impulse to both punish and save finance reflects society’s conflicted aims. Voters want banks that can fail, just not now. Creditors must pay for failures, but when creditors get wary, the authorities rush to prop up markets. Banks must shrink and have big safety buffers, but not if that risks a double-dip recession. To reconcile these aims is a tall order.

America’s package is an important step (see article). Its best bits should cut the odds of bad stuff happening. The Federal Reserve will get powers to police almost all big firms, ending some regulatory turf wars. A new consumer-protection agency will combat dodgy lending. Many derivatives contracts will be brought into the light by being put through clearing houses and exchanges. There are some less-than-convincing bits: banning banks from proprietary trading feels good but won’t make them much safer; the package doesn’t tackle Fannie Mae and Freddie Mac, the failed housing agencies; and legislators could include some harmfully draconian prohibitions on derivatives. Still, overall, it does more good than harm.

Build up the buffers

Yet the assumption must be that crises will still happen. Hence it is vital that banks carry bigger safety buffers of capital and liquid assets. This job has been outsourced to the Basel club of regulators, which aims to finalise its proposals by the end of the year and implement them by December 2012. Behind the scenes an almighty brawl is raging (seearticle). Banks dislike some of the fine print and also claim that the cost of “Basel 3” will force them to raise the price of loans, devastating the economy. The French Banking Federation, for example, reckons it could eventually knock more than 6% off the euro zone’s GDP.

That is just one estimate—the Basel club will produce its own study later this year which is likely to be less alarming. But it will still face an onslaught and to do its job it will need to appeal to a wide audience, in the language of common sense. It must make clear that the timing of bigger buffers can be staggered and that their cost must be compared with the benefit of fewer meltdowns (the Bank of England reckons global GDP in 2009 would have been 6.5% higher without the crisis). And it must insist that as a bare minimum the system has enough capital and liquidity to absorb a crisis as bad as the last one.

The good news is that big banks probably now have enough capital to absorb the aggregate loss rate suffered by the system from 2007 to 2009 (although their build-up of liquidity reserves has been patchier). But buffers can be set at these pragmatic levels only if there is a credible way to deal with the outlier banks that typically lose three to five times more than the average. This is why “resolution schemes” for bad banks, that put losses onto creditors not taxpayers, are so important. They are a linchpin of reform, allowing politicians to argue that bail-outs will not happen again and regulators to resist calls for bigger safety buffers or a radical break-up of banks.

No existing proposal looks sturdy enough. America’s reform package and the industry’s plans will create the bureaucratic tools to push losses onto creditors. But will they be used? In a crisis supervisors will still be terrified that the threat of hundreds of billions of dollars of losses will fuel panic. Faced with a near collapse they are far more likely to give banks’ creditors a guarantee than to hurt them.

What may be needed is a rejigging of banks’ balance-sheets to try to contain this panic, with a clearer line between those who bear losses, including shareholders and junior creditors, and those, such as depositors, senior creditors and counterparties, who can be assured of business as usual. The Basel club is now making a stab at this task as well as trying to co-ordinate resolution schemes globally. Unless it succeeds, every time banks’ borrowing costs rise, the response will not be satisfaction that investors are discriminating against weak firms, but dread that things may spiral out of control again.