Let's build a bank system that welcomes failure

The key to financial regulation post-Lehman is not ensuring that financial institutions don't fail but rather reducing their interdependence so that they can.

FT.com

When the global worldwide banking system went into meltdown in 2007-08, the short-term response – the appropriate one – was to use public money to prevent a sequence of collapses of financial institutions. But the right long-term response is not to try to stop future bank failures, but to construct a global financial and economic system that is robust to individual bank failures. That is a fundamentally different objective.

It has proved difficult to find executives and management systems able to control the risk exposures of large financial conglomerates: even the halo above Jamie Dimon looks tarnished. To believe that the control these managers failed to establish will be achieved by the supervisory efforts of junior officials in public agencies is a delusion. Even if regulators had the technical competence, they do not have the political backing. Hotlines from bank boardrooms to ministerial offices are answered as promptly as ever.

Public opinion excoriates regulators for their ineffectiveness as it nurtures exaggerated expectations of what future regulation might achieve. Establishing bodies with grand-sounding responsibilities for global financial stability represents only a tiny step towards these goals.

Regulation based on target capital ratios not only failed in the past, but will fail again in the future. Not because the fine print of the risk weighting is defective, but because any target will be gamed by those who observe its letter rather than its spirit. The achievement of the regulatory reform agenda has been to ensure that when the next financial crisis occurs it will not take exactly the same form it did in 2007-8. The objective of preventing individual bank failures will largely be accomplished, but by socialising much of the downside risk in the financial system, rather than by addressing the underlying issues.

Effective reform should aim at structures, not at intensified supervision. Resilient systems are simple ones. The most effective supervisors of financial institutions are not bureaucrats but other financial institutions. These principles should be fundamental to a new approach and they have wide implications.

Bad lending in the US mortgage market and the creation of debt instruments were only proximate causes of the 2007-8 crisis. The establishment of complex financial conglomerates, whose assets and liabilities were mainly the liabilities and assets of other financial conglomerates, created a structure in which minor disruptions were likely to have large and unpredictable consequences throughout the financial system. This issue cannot be addressed by establishing committees to watch it happen. To respond by public insurance of the structure is dangerous, not just because it imposes obligations on taxpayers but because it largely relieves private actors of the obligation to monitor their own counter-party risks.

Alan Greenspan expressed puzzlement that shareholders and managers of banks had not controlled risk more effectively. But shareholders who provide less than 5 per cent of the capital of a business are not equity participants, but owners of a call option: in turn, corporate executives with bonuses and remuneration plans hold options on these options. How can we expect stability when volatility increases the value of the instruments owned by the people who make or influence all important decisions?

The true equity participants in highly geared ventures are the owners of debt who are now reassured that the businesses in which they invest are "too big to fail”. We need instead smaller, simpler, financial institutions, which specialise in particular lines of provision of financial services to the non-financial economy, rather than trading with each other. The only sustainable answer to the issue of systemically important financial institutions is to limit the domain of systemic importance. Until politicians are prepared to face down Wall Street titans on that issue, regulatory reform will not be serious.

Copyright The Financial Times Limited 2012.