A dangerous consensusSeptember 2009
In A dangerous consensus Nicholas Boys Smith outlines the risks of large scale government intervention into the banking sector following the global financial crisis. He identifies the danger of a "comfortable, corporatist consensus" that "the world apparently needs nothing more than to close down the 'casino banks', ban dangerous speculative innovation and return to a sort of updated, over-regulated post-war corporatism in order to recreate the happy days of the 1990s". Such simplistic approaches will make future banking crises more, not less, likely and hold back economic recovery.
Nicholas Boys Smith identifies that regulating bankers' bonuses will make the public feel better but will achieve nothing. The public's anger as they see their taxes save institutions that have paid over so many billions in bonuses may be entirely just and the political desire to "do something" entirely natural. Nevertheless, some of the organisations that failed most spectacularly were actually quite sensible in their approach to long term incentivisation. Enacted unilaterally, as the UK appears to be happy to do, regulating bonuses will merely encourage banks to base critical posts abroad.
Global attempts to bring all financial centres under the same regulatory regime will fail. There is a rationale for this action (preventing regulatory arbitrage or the "race to the bottom") but the end will be unattainable and the series of compromises and trade offs necessary to achieve it will without doubt lead to staggeringly foolish and arbitrary rules. Efforts to improve international cooperation should focus on making it easier to wind down cross-border banks. The European Union should not be permitted to take control of financial services regulation in the UK. Their current proposals could hardly be more foolish or more ill-timed.
Bullying banks to lend domestically will undermine global trade and prosperity. The medium term implications of such an approach may lead to cross-border lending being discouraged too effectively in too many countries. International investment and lending will be one of the necessary routes out of recession. Preventing it, in a sort of financial version of 1930s protectionism, will merely delay recovery.
Hedge funds do not need increased levels of regulation. Unlike already heavily regulated banks, hedge funds did not cause the credit crunch and there is no evidence that they need increased levels of regulation. Banning short selling will merely make the market less liquid (which was the problem the credit crunch created, not a solution).
Careless product regulation and simplification should be avoided. Some of the "problem products" of the crunch (securitisation, credit default swaps, etc.) need sorting out so they are never again so opaque. But many of the necessary changes are already well advanced - because the market demands it. While it may be necessary for national regulators to chip in, they should keep their prescriptions minimal. Overly-precise rules will either just become irrelevant in time or close down markets within given jurisdictions.
Nicholas Boys Smith proposes that sensible reform of the financial sector should contain the four following features:
Simple information on bank stability and safety should be provided. The risk, capital and information that banks file for their accounts and for their regulator should be clear, utterly transparent and available to all investors, depositors or commentators.
Deposit insurance moral hazard should be reduced with flexible pricing. To maximise the benefits of insurance banks should be allowed to choose their optimum business model - whether it be "pure" retail banks collecting deposits and offering mortgages or more universal banks competing in the full range of corporate and capital market operations - and with price of insurance varying among models.
A more flexible, judgement-based approach to capital, liquidity and balance sheets should be introduced. The inflexibility of the Basel accords needs to be addressed. Banks have been permitted to use the profusion of "off balance sheet vehicles" to absorb risks that should have been represented on their balance sheets. The entire regulatory framework has been too fixed through the credit and economic cycles. Future capital and liquidity ratios should be more credible but also more flexible.
Banks should be able to fail. It is not simple to wind down a multi-billion dollar cross-border bank. It should be easier so that they can collapse without the market panicking. This is a legitimate sphere for government action. There is definite scope for clearer international rules for banks' orderly winding down with ultra-rapid settlement of any deposit insurance claims. And it should be very simple for former competitors to purchase parts of a failing bank.