Mervyn King (not the famous South African one) – now Baron Mervyn King of Lothbury – was once a highly influential Professor at the London School of Economics and then the Governor of the Bank of England until 2013, during which time he helped guide the UK successfully through the financial crisis.
(More recently, he resigned from the Board of the Aston Villa Football Club, the team that finished last in the English Premier League this season. Since past performance is no guide to future performance (in football and in financial markets) this surely will be forgiven.)
King has written a book “The End of Alchemy” to express his disquiet with the post financial crisis banking system and how it is being regulated1. To quote King: “The strange thing is that after arguably the biggest financial crisis in history nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.”
The fundamental problem, King argues, is in the nature of the incentives banks have in taking risks with other people’s money. When the risk taking works out, the bank shareholders and managers get the rewards, while society has to bear the fall out when the risks turn out to have been very poorly managed. But is this heads I win – tails you lose asymmetrical risk-reward nexus that different for banks when compared to all other large listed companies?
The rewards for managers and shareholders in any company who take on sometimes highly leveraged risks of failure and then succeed (against the odds) can be enormous. The losses caused by the failure of a large public company can also be very serious for the economy at large – other suppliers or customers. They may well be sucked into bankruptcy should the firm suddenly have to close its doors and workers and managers will have to seek alternative employment. The larger the company or bank, the larger these potentially damaging knock-on effects. But if a company or bank is growing for good economic reasons, it would be poor policy to prevent this growth in efficiency for fear of subsequent failure.
The direct financial losses of business or bank failure will be typically borne by shareholders, whose stake in the winning or losing enterprise will be a small part of a low risk, well-diversified portfolio. These lower risks means less expensive capital for the risk taking firm and so more incentive to take on risk. Yet without limited liability for losses, very little risk taking would ever be undertaken. Society has every good reason to encourage risk taking by banks and others – it is the source of all economic progress – and to provide limited liability for capital providers.
Yet the long and mostly successful history of banks and other limited liability companies is that the price of success – the willingness to accept and deal with business and banking failure – has been well worth taking. The focus of policy should perhaps be on how to improve the defence against actual failure, rather than interfering with the freedom of banks to usefully put capital at risk, in the hope that this will prevent a crisis, by introducing better bankruptcy laws that can act much faster to get a business back on its feet and convert debt into equity to the purpose. This will provide debt holders – especially less well diversified lenders – with every incentive to monitor risk management by a bank or business and to introduce debt covenants to such purpose. Ordinary shareholders, even well diversified ones, will greatly appreciate such surveillance, making a mix of debt and equity finance a desirable one.
A business may well be worth rescuing if the reason for failure is too much debt rather than a poor operating performance. Furthermore, a reliance on central banks to restore macroeconomic stability when threatened by a financial crisis, that can be impossible to predict or avoid, is an essential and appropriate part of these defence mechanisms. The history of central banking is the history of how central banks, beginning with the once privately owned Bank of England (nationalised only in 1947) coped with financial crises.
Banks are however responsible for the management of the economy’s payments system. The payments system, hence the banks, cannot be allowed to fail; not even temporarily. The consequences would be too ghastly too contemplate, as they are being forced to contemplate in Zimbabwe as we write.
The interest spread between what a bank offers for deposits and receives for loans has helped to subsidise the cost to the banks of running the payments system. The customers of banks do not typically pay transaction fees to cover the full costs of the payments system they utilise. Hence the attractions of cheap funding for the banks in the form of very low interest transaction accounts and attractions for their customers in the form of low cost transactions that make up for low interest rates received. A comparison of bank charges with charges made by vendors using credit card systems or with the percent of the value of a transaction charged by the money changers and transmitters, makes the point. I am told that for every R100 transferred for example to Malawi through the banking system, the receiver will receive R90 at best. How much of the 9% charge goes to the banks, to the money change agents and the government, I do not know.
The business case for bundling bank borrowing, lending, trading and making payments may however be breaking down. Blockchain computing is being used to safely and cheaply move valuable Bitcoins around the world. The technology could extend to transactions effected by specialist electronic money-changers, charging low fees that still cover low costs. Pure transaction accounts could be made fully and always backed by reserves of central bank deposits or notes in the till or ATMs, rather than covered by deposits or reserves held with other more vulnerable banks. If transactional banking can be legally and economically separated from risk taking banking, the all-important payments system can be insulated from the danger of banking failure. Banks, as with other firms, can then be left to manage their own risks. This may well be the way to rescue banks – or rather their risk-absorbing shareholders and debt holders – from the profit-destroying and cost-raising burdens imposed by risk-avoiding regulators.
1These observations were stimulated by an article by Michael Lewis: On The End of Alchemy – A Central Bankers Memoir (Mervyn King Of The BOE), Actually Worth Reading, Bloomberg Business, 6 May 2016