October 22, 2009 8:31 pm

Why curbing finance is hard to do

About a month ago, I visited the aero engine factory of Rolls-Royce, in Derby. I was hugely impressed. Making jet engines able to work at extreme temperatures is an extraordinary achievement. Why does the financial industry not work this way? How might we bring the performance of finance close to that of other sophisticated businesses?

This is, in its essence, the question Mervyn King, governor of the Bank of England, was addressing in his controversial speech this week. His answer: break up the banks into “utilities” and “casinos” The former would be safe. The latter would live and die in the market.

Both Alistair Darling, the UK’s chancellor of the exchequer, and Gordon Brown, the prime minister, promptly slapped Mr King down, arguing that this division does not work: Northern Rock, a utility mortgage-lender, failed, while the collapse of Lehman Brothers, evidently a casino, led to the most expensive financial rescue yet. This, they argue, is a misdirected remedy: the distinction between utility and casino either cannot be drawn or, if it can, does not coincide with the distinction between what has to be safe and what need not be. Yet it is evident why this distinction is appealing. If we define the utility parts of the financial system narrowly, as management of the payment system, it works like clockwork. It is in the management of risk (and the advice given to its clients) that the financial system fails. The limited liability businesses at the heart of our credit-based monetary system have a tendency to mismanage risk (and uncertainty), with devastating results.

Over time, the policy response has been to cushion their creditors from the consequences. But this effort to make the system safer has made it ever more dangerous. Today, as a result of this last crisis, we see, at the core of the system, behemoths whose creditors know they are too significant to fail. As Mr King, remarked, “the massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ problem is too important to ignore.”

Mr King raises the right issue. He is justified in doing so, even if it makes politicians uncomfortable. Indeed, he is justified, because it makes politicians uncomfortable. I agree with him, too, that the two alternatives are either to make institutions that are “too important to fail” too good to do so or to be able to fail any institution, even in a crisis. If we do not achieve one of these, further crises are inevitable.

Yet I remain unpersuaded that the structural solution – the separation of utility from casino finance – is workable, as I pointed out in a column on the “narrow banking” proposal of my colleague, John Kay. Indeed, Mr King himself is well aware of the difficulties.

First, the border between utility and casino banking is impossible to draw. For Mr Kay, the utility is the payment system and protection of deposits. This would leave all lending – including to households and businesses – inside the casino. For those in the US who hark back to the Glass-Steagall Act, the distinction is between commercial and riskier investment banking.

Mr Kay’s distinction is clear, but problematic. If we followed him, all risk management would become unregulated. It is inconceivable that governments would, or could, leave them so. If we moved back to a Glass-Steagall distinction (itself never accepted in continental Europe), we would need to draw a line. But where? Why would lending to households and business be good, but securitising those loans bad? Why would hedging be good, but speculating bad and how might one draw the line between them? Mr King counters that prudential regulation already draws such distinctions. I would respond that regulation has made a mess in doing so. Furthermore, these are not distinctions between businesses.

This is not to argue that there is no way of making finance safe. There is. But it would be far more radical: deposits would be 100 per cent reserve backed; and the liabilities of other investment vehicles would be adjusted for the market value of their assets at all times. Banking would disappear.

Short of such radicalism, we must approach the task in a more subtle manner. First, create a set of laws and institutions that make it possible to bankrupt any and all institutions, even in a crisis. Second, make financial institutions safer, with much higher capital requirements, against all activities. Third, prevent off-balance-sheet activities. Fourth, impose dynamic provisioning. Fifth, require huge cushions of contingent capital. Finally, cease to favour debt-finance, throughout the economy.

If we did all this, the world of finance would be duller and safer. It would still not have the reliability of jet engines. So long as we allow people to make leveraged bets on the future, breakdowns will occur. The division of finance into utility and casino cannot solve this problem. Only the end of leverage would do so. Do we want that? I doubt it.

More columns at www.ft.com/martinwolf

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