The Libor scandal has nailed the coffin of the banks’ reputations shut. After a huge financial crisis and a long list of scandals, banks are now viewed as incompetent profiteers run by spivs. Such disgust over what Paul Tucker, deputy governor of the Bank of England, has called a "cesspit” is quite natural. But disgust alone must not shape reform. Here are my seven suggestions of how best to respond.
First, accept that misbehaviour is going to happen, particularly where so much money is at stake. It is good that the public reacts strongly, since that will discourage managerial insouciance. But let us be realistic: bankers are in this for the money and, like it or not, always will be.
Second, there are ways of lowering the risk of such a scandal being repeated: heavy penalties are one, more transparency another. Data for actual transactions should be used. Transparency is no panacea for the ills of banking. But it would help.
Third, banks need far more equity. This, too, is relevant to the Libor scandal. Regulators would have been far less worried about relatively high reported Libor rates in October 2008 if people had not believed the banks were dangerously close to collapse. The answer to that fear is more capital, as Robert Jenkins, a member of the Bank of England’s new Financial Policy Committee, has argued in a superb recent speech.
Fourth, more equity cannot mean 100 per cent equity. Laurence Kotlikoff suggests not what he calls "limited purpose banking”, but the end of banking. I accept that leverage of 33 to one, as now officially proposed, is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.
Fifth, in setting these equity requirements, it is essential to recognise that so-called "risk-weighted” assets can and will be gamed by both banks and regulators. As Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk. For this reason, unweighted leverage matters. It needs to be far lower.
Sixth, the case for implementing all the recommendations of the Independent Commission on Banking, of which I was a member, is now even stronger. In particular, it remains vital that banks be easily resolved, in the event of mishap: ringfencing of the retail banks, where continuity of service is essential, should facilitate this. It is also vital to ensure that subsidiaries and the group as a whole have both sufficient quantities of equity to be credibly solvent under nearly all circumstances, and sufficient loss-absorbing debt to be resolved, should they get close to the margin of insolvency. In brief, banks need a large margin of safety, at all times.
The ringfencing of retail banking should also reduce its contamination by the short-term trading culture of investment banking. This is one reason why the government should reconsider its decision to let retail banks provide 'simple' derivatives. But do not be naive about this: retail banks can both misbehave and fail.
Indeed, a question the UK must now face is whether a sound model of retail banking exists, given today’s low interest rates. I would argue that the painful history of scandals in retail banking, including the brutal treatment of unauthorised overdrafts and the misselling of "payment protection insurance”, reflects the absence of sound charging for the costs of providing banking services.
Finally, I see no more persuasive a case for full separation of retail from investment banking than before the scandal, provided funding of the latter is separated from the deposit base of the former. Retail banks must also retain adequate equity. Remember that retail banking is also risky. Diversified groups are able to help out their subsidiaries in a crisis. The proposed ringfence would deliver exactly what full separation can do, but retain the benefit of diversification in a larger group.
Of course, with higher capital requirements and the loss of both captive deposits and the implicit subsidy from governments, the cost of funds to investment banking would rise. But that would surely be healthy. If the pay of bankers were also aligned more closely with the interests of junior creditors, many of the more irresponsible forms of risk-taking should in time disappear.
It is understandable that recent scandals have enraged the public. But rage is always a dangerous basis for policy. The days when the local bank manager was almost as respected as the doctor have long gone. We are never going to turn bankers into saints. But we can change the incentives facing bankers, the structure of banking and the focus of regulation. Where I would go further is towards substantially lower leverage and significantly greater transparency. Not least, I would do everything I can to eliminate the idea that the state stands behind investment banking. That is an insane idea. This is one reason why the ringfence is vital.
We cannot hope for miracles. But we can make bankers more useful and less dangerous. Focus on that.
Copyright The Financial Times Limited 2012.