Tuesday, 17 April 2012

Modern Titanics (2) - The financial sector

Complixity of Dodd-Frank reform after the crisis

Everybody knows the world's financial system was on the verge of total freezing and collapse between September 2008 and March 2009.

The causes are plenty but above all it was a failure of regulation.   I had written extensively about this in a study I had published in February 2010.  Link hereunder:


Typically regulators' reaction to this was something which does anything but regulate.   They introduced additional regulation which is so complicated that banks can easily wriggle out of it arguing that it is counter-productive and therefore things should stay as they are.

An indeed things are staying as they were,  as if no financial crisis has ever happened:
  • Banks that were too big to fail are even bigger
  • Bank bonuses are still atrociously and scandalously huge - Barclays' Bod Diamond, who was saved twice by lady luck rather than skill, carries the arrogance flag here
  • Career investment bankers are still taking overall charge of utility banks - the only exception is Moynihan of Bank of America
  • Banks are still growing casino trading sections on the argument that it is difficult to distinguish between speculative proprietary trading and trading through market making arrangements to serve clients.
  • Complex products are still being issued with annoying regularity and they are as complex and opaque as ever
  • Banks in the US quickly repaid back the rescue funds government gave them when they were in the eye of the confidence storm so as to free themselves of restrictions attached to such funding, including remuneration and dividend restrictions, and go back to their old habits as quickly as possible.
After hitting the iceberg and after being rescued by government, banks are back on the Titanic cruising full speed ahead assuming that the next crisis is many moons away, and that in the meantime huge short term trading profits and bonuses can be squeezed; that when the next iceberg will be hit, governments will be there again to rescue them.  Really  a perfect example of moral hazard, a case of privatising profits and socialising losses.  

How free marketers can justify such an attitude defies all logic.

What was necessary was very simple regulation which could have been written on two A4 pages.   Basically the regulation should have said that if you are a bank that takes retail deposits which are covered by the deposit insurance scheme, then you have to be a utility bank and you cannot do any proprietary trading, market making including, but can only trade on behalf of clients and execute clients orders.

Obviously banks would still want to do investment banking which in the good times is very profitable.   Banks that wanted to do this should have split themselves in two, a utility bank and a casino bank and issue different shares to shareholders who can thus decide on how much risk they want to carry by deciding which shares to keep and which to sell.   Similarly subordinated and hybrid bonds would have had to decide to take a cut in coupon to stay with the utility bank or keep the coupon and go with the casino bank.

The Casino bank would have to remove the word bank from their title and can speculate as much as they want but not with insured deposits.  They can speculate with their own investor funds and with high yield bond investors who choose high coupon over better security.

In this case, banks would no longer remain too big to fail and the taxpayer will not be short changed again as happened in the 2008 crisis, where governments took enormous risks to save banks without getting commensurate rewards for taxpayers.

We are still sailing the Titanic towards a bigger iceberg which we will hit in three, five, ten or twenty years time.  I don't know when.  But hit it we will!!

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