[R-G] [BillTottenWeblog] The Fire Next Time

[Bill Totten]

Every attempt to make banks more responsible has made them more
reckless. Unless the sector is radically reformed, future meltdowns will
make the current crisis look routine

by James Buchan

New Statesman (November 13 2008)


As the financial chaos that began with the collapse of Northern Rock in
2007 enters its second year, the question is: where do we want to be?
Are the banks, as the British Chancellor of the Exchequer Alistair
Darling has said, to use public capital to restore the relatively
free-and-easy commercial conditions of the latter part of 2007? Or
should we, as both Gordon Brown and Nicolas Sarkozy have suggested, try
to use the 15 November meeting of the twenty chief industrial countries
in Washington to establish a new era, like Bretton Woods in novelty if
not character? With a new US president, in the person of Barack Obama,
due to take office in January, the opportunity is for the taking.

Financial crises are like fireworks: they illuminate the sky even as
they go pop. The disruptions of this autumn, the bank rescues, falling
securities markets and currency turbulence, have revealed cracks and
chips not merely in our financial system but in our general way of
looking at the world. The expertise of the economists looks suddenly
threadbare. As Robert Skidelsky, John Maynard Keynes's biographer, wrote
in the Washington Post last month: "What is in even shorter supply than
credit is an economic theory to explain why this financial tsunami
occurred, and what its consequences might be. Over the past thirty
years, economists have devoted great intellectual energy to proving that
such disasters cannot happen."

Any new financial order for the world must tackle the three chief
challenges of our age. The first is the privileges enjoyed by people in
the banking and securities trade on a scale which would not have shamed
the nobility of the ancien régime. The second is the perverse character
of modern investment, by which financial surpluses generated by
hard-working countries are channelled by the banks not to undeveloped
nations that might turn them into prosperous future markets, but to the
spoiled and elderly economies of western Europe and the United States,
already awash with unproductive capital. The third is our most pressing
engagement, which is to prevent further ravages to the natural
environment and the general amenity of existence from the reckless
combination of the previous two challenges.

The banking crisis that began in earnest with the failure of Lehman
Brothers Holdings on 15 September, has lost its novelty as a public
spectacle. As people turn back to their ordinary preoccupations, and to
the prospect of President-elect Barack Obama, the bankers are lifting
themselves up, dusting themselves down and preparing to do what they
were doing before, only this time with GBP 400 billion of public money.
However frightening the events of September and October, they were not
frightening enough. As Eric Daniels, the chief executive of Lloyds TSB,
put it: he did not expect the government, which has earmarked GBP 17
billion for a merged HBOS and Lloyds TSB, to "have an impact on our
lending policies or conduct of business". At times our financiers sound
like the Bourbon kings, who learned nothing and forgot nothing.

When the Bank of England cut the main rate of interest at which it lends
to commercial banks on 6 November, by no less than 1.5 percentage
points, the British banks must have thought Christmas had come early.
When you can get your funds at an interest rate of three per cent and
lend at seven per cent, it is not hard to make money. With these
windfall profits, the banks could soon rebuild their capital, repay the
public loans and start making themselves lots of money.

The Chancellor and his team had other ideas. At a meeting at the
Treasury on 7 November, senior commercial bankers were reminded, with
the aid of some pertinent press cuttings, of just how unpopular they
are. Now that the public owns Northern Rock and Bradford & Bingley, and
is about to part-own Lloyds TSB, HBOS and Royal Bank of Scotland,
ministers can no longer be ignored. Even Barclays, which has gone to
great effort to avoid taking the UK government's money, raising GBP 5.8
billion at higher rates and more unfavourable terms from reluctant
investors in Abu Dhabi and Qatar, is faced with the same public distrust
and political interference.

Losing your capital is like losing your trousers. It is a real
humiliation, and one not to be soon repeated. The British banks will be
forced by the government to advertise attractive mortgages and other
loans, but they will only make these loans on good security, and it is
security that is in short supply. In the market for private housing
finance, I imagine we will revert to the conditions of the 1970s, when
buyers were expected to provide a quarter or even a half of the purchase
price. Northern Rock, which has been longest at this sort of
retrenchment exercise, had already reduced its outstanding loans by ten
per cent by the middle of the summer. The Bank of England estimates
that, even with the extra share capital underwritten by the government,
the largest UK banks would need to reduce their books of loans by around
one-sixth to revert to the normal or half-normal level of 2003.

Banks will also try to shrink their establishments, bloated beyond all
reason during the boom years or, as in the case of bank branches,
maintained out of idleness and sentiment. If Lloyds TSB manages to
consummate its union with HBOS, it intends to cut GBP 1.5 billion per
annum by 2011 in overheads, particularly wages, from the combined
business. A rough calculation suggests this could means a reduction of
20,000 staff.

At the heart of banking is a suicidal strategy. Banks take money from
the public or each other on call, skim it for their own reward and then
lock the rest up in volatile, insecure and illiquid loans that at times
they cannot redeem without public aid. Put another way, the assets of
the banking system belong to the joint-stock banks, but their
liabilities (as we have learned in the past two months) are always and
only public liabilities. I guess that is what the Chancellor means when
he talks of the "part-nationalisation" of the banking system.

It is a dilemma that goes back to the origin of joint-stock banking at
the turn of the 18th century. Whereas private bankers staked their
credit, reputations and fortunes on their decisions to lend or not to
lend, the shareholders and managers of joint-stock banks carried no such
responsibility. That is why, in Britain at least, it was not until the
1870s that joint-stock banks received the protection of limited
liability. Until then, their shareholders were liable for losses to the
extent not just of their shareholding but of their entire property.

All attempts to regulate the banks have made this prudential problem, as
it is known, worse. The Bank of England, which like so many institutions
has suddenly become obsessed with history during the crisis in the same
way that other people "get" religion, published in its latest Financial
Stability Report a chart showing the effect of regulation on the caution
of American bankers. In the 1840s, American banks held on average one
dollar in their own funds to two dollars of loans and other assets such
as government bonds. That meant that half their money was not earning
anything, but also that half their loans could go bad without causing
loss to depositors.

With the Civil War and the passing of the National Bank Act in 1864,
that proportion fell to 25 per cent. In 1913, the Federal Reserve was
founded and the proportion fell to 18 per cent. Since then, the bankers
have managed to get various classes of asset exempted, and the
proportion has fallen to under ten per cent. Each attempt to make the
banks more safe has made them more reckless. According to the Financial
Stability Report, before the crisis of this autumn the chief UK banks
had GBP 200 billon of their own capital to support GBP 6 trillion worth
of lending, a proportion of one in thirty. As the Bank notes in a sort
of wonder at the majesty of financial phenomena: "Recent events have
illustrated that banks can now incur losses much faster than they can
recapitalise themselves in stressed market conditions".

By choking off lending, the banks have set in train a decline in general
trading activity that looks to be worse than those of 1991, 1982 and,
possibly, 1974. My suspicion is that the semi-orderly contraction in
bank lending envisaged by the Bank of England will drop us off in
roughly the same place as if the likes of HBOS and Royal Bank of
Scotland had been bankrupted. That, of course, can never be tested. Yet
the result of the government rescue is to entrench a sort of banking
nobility, endogamous and permanent, without responsibility and not
subject to ordinary commercial law. It reinforces the vacuous and
illiterate City culture of pecuniary display, cost-free philanthropy and
nuisance travel. And it perpetuates banking practices whose eventual
disintegration, ten or fifteen years in the future, will make this
crisis look routine.

So what is to be done with the banks? My own modest proposal, which has
not many adherents, is to take away from joint-stock banks the privilege
of limited liability which they abuse every moment of the day. That
would certainly separate the sheep from the goats but would, perhaps,
reduce the equity capital available to the banking system a little too
sharply.

More realistically, now is the time for government authorities to begin
slowly to peel back some of the other privileges, such as deposit
insurance, that under the guise of protecting the public, merely protect
the banker. What this means is that you and I will think for a moment
before entrusting our money to a bank. We might ask for a balance sheet
at the counter, the work of a few moments. We don't know how to read a
balance sheet. The clerk will show us. The public, turned into infants
by bank regulation, become adults again. Banks will be obliged by a
discriminating public to carry more of their own capital. At Bradford &
Bingley, the pretty woman in a green bowler becomes a plain man in a
black one.

The second challenge, which arises from the imbalance of savings between
west and east, is one that Keynes would have recognised even if, in his
time, it was the US that had the money. The tendency of the west to
borrow and spend and the east to save and lend is the shadow or phantom
behind the banking crisis. China, Japan and the oil-exporting countries
earned such colossal surpluses from their exports that they could find
no other home for them than the indebted households and governments of
the rich countries. In the case of the two Chinas, Japan, Russia and
India, these hoarded surpluses exceed the entire resources of the
International Monetary Fund, the institution set up at Bretton Woods to
assist distressed countries needing access to foreign currency for their
trade.

Meanwhile, the turmoil in the banking system has meant that entire
countries - Iceland, Hungary, Pakistan and most of the poorer nations -
can without warning lose all access to foreign currency to buy food for
their populations. The answer is to increase the resources of the fund
or some successor while recognising that the world has changed out of
all recognition from 1944. The US is now a debtor, not a creditor, and
the rich new powers of Asia need representation according to their wealth.

That leads to the final challenge of limiting the damage to the natural
environment from the rapid expansion of trade and population in recent
years. Even before the banks fell to bits, energy and grain markets,
movements of people and climate patterns were frantically signalling
that something was going awry with the worldwide commercial system.

At one level, the decline in business activity will be a blessing.
Certain perverse projects, such as the expansion of the London airports,
will not pay for themselves in the new world of tightened belts and shut
wallets and must be delayed or even, God willing, abandoned. It is one
of the bizarre features of our civilisation that money will do for its
own preservation what we, for our own welfare, will not.

Here the conjunction of a new US administration and a disgraced business
and financial Establishment is interesting, to put it mildly. If the
investment, for example, necessary to limit or reduce carbon-dioxide
emissions appeared to sceptics both uncertain and costly, the $3
trillion cost of cleaning up the current financial mess puts it into
perspective. If some latter-day New Dealer is looking for
counter-cyclical investment both to keep people in work and to raise
public morale, the environment is by far the most promising field of
activity. For example, the Detroit carmakers have jogged along for more
than eighty years on a rich and combustive mixture of cheap gasoline and
easy credit.

That era is now over, which is why the US motor industry is by almost
every prudent measure utterly bust. There is no purpose in Barack Obama
summoning from the tomb the corpse of Henry Ford. Any rescue operation
in Detroit must take account of the new world of tighter credit and
environmental standards and more costly motor spirit.

To concentrate merely on regulating the financial sector might buy
stability for a year or two, but the weaknesses in energy and food
supply and the degradation of the environment will not go away. The
rainbow over the downtown skyscrapers will have but one meaning: no more
water. The fire next time.

_____

James Buchan is the author of Frozen Desire: an Inquiry into the Meaning
of Money (1997). His latest novel, The Gate of Air, is published by the
MacLehose Press (14.99)


http://www.newstatesman.com/economy/2008/11/banks-public-financial-money


TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/