Can we avoid another bank crisis?

Since the GFC, regulators and politicians have been all over the banks like a cheap suit: no more rate fixing scandals; rogue trading has been banished; and drug cartels and terrorists have been laundering money through casinos rather than HSBC.

And what a transformation! Beach houses given over to the destitute; Porsches sold to finance community vegetable gardens; money idling in tax havens directed to wind power research. At lunchtime in Martin Place, bankers gather to hold hands and meditate.

Their gratitude to taxpayers for first allowing them to get rich, then for bailing them out when they screwed up, and finally for not sending them to jail, is deeply felt. The greedy have become the grateful. It can never happen again.

Nice thought isn’t it, and completely fanciful. What should be done?

Could we send a few bankers to jail as a start?

That’s a novel idea for sure, one that regulators clearly haven’t considered. Unfortunately, revenge won’t solve the problem. An aggrieved populace could line the Thames and the Hudson Rivers with ducking stools and publicly torture the miscreants. It might make us feel better but the problem isn’t with individuals. It’s the system in which they work.

So it’s a systemic problem?

Yes. Banking used to be a simple business: A customer deposited money and received interest on it. The bank would then lend it out at a higher rate. Once banks realised depositors didn’t ask for their money back all at once, they could lend even more, which made them even more profitable, and more risky.

Banking isn’t like that anymore. The system is too complex and interlinked to survive bank failure. Remember how LTCM almost bought down the entire system in 1998? The industry is a series of dominoes; when one falls, they all do. Some call it ‘too big-to-fail’, others ‘too big to save’. It amounts to the same thing, either way.

How do you prevent a system collapse?

We need to be able to let a bank fail without it bringing down the whole shebang. Let’s take the domino metaphor a little further to explain it.

Tim Harford in his book Adapt: Why success always starts with failure recounts how a domino-toppling record attempt was ruined when a pen dropped from a person’s pocket and knocked one over. Domino topplers then introduced safety gates that were ‘removed at the last moment, to ensure that when accidents happened they were contained.’

In 2005 a sparrow flew into a hall in which over four million dominos had been erected by a 100-person Dutch team over a period of two months. The evil-doing bird knocked one over but the safety gate system contained the damage—only 23,000 dominoes fell, barely a morning’s recovery work.

The banking system needs a simple safety gate system like that. Andrew Haldane of the Bank of England nailed it in a paper called The dog and the frisbee: ‘In financial regulation, less may be more’. Complex rules managing complex systems increase rather than reduce risk. We need simple rules for a complex, interconnected system.

Have regulators learnt that lesson?

Hardly. There have been two main policy responses to the crisis.

In the US in 2010 The Dodd-Frank bill was passed. The draft ran to 1,300 pages. The bill itself was 2,600 pages long and spawned 65 studies, 243 new rules and over 100 committees.

Basel III is better. It targets a range of measures to protect ‘systemically important banks’ and runs to 616 pages, although none explain what ‘a systemically important bank’ is. Odd omission.

The measures force banks to hold common-equity capital of at least 7% of their risk-based assets (before the crisis, it was a mere 2%), reducing banks ability to lend (leverage) and therefore its risk.

Basel III also tries to simplify the regulatory framework. It’s a far more useful effort than Dodd-Frank, mainly because Wall Street lobbyists were less effective in hobbling it, but it isn’t a true safety gate, more another layering of complexity.

What should we do?

I was afraid you’d ask that. EF Schumacher is believed to have said, ‘any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius—and a lot of courage—to move in the opposite direction.’

The first thing we should do is encourage banks to hold more capital. Basel III does that. It also contains a mechanism that discourages credit growth in boom times and encourages it when times are tough. Both are sensible measures.

Decoupling could also be enhanced with the separation of critical retail banks, which hold depositors' money, from more risky but less systemically important investment banks.

In 1933, the Glass-Steagall Act enforced the separation of commercial and investment banking but, thanks to bank lobbying, it was repealed in 1999. Even Sandy Weil, former head of Citibank and a campaigner against Glass-Steagall, called for its reintroduction in July of this year.

It wouldn’t be a touch of genius to reintroduce Glass-Steagall but it would require courage. Thus far, politicians haven’t shown it.

We also need a far quicker way of resolving bank failure when it occurs. Sweden during its bank crisis of the early 1990s showed how important it was for regulators to be able to take over banks and quickly restructure them. It emerged from a bank crisis quite quickly.

After the GFC, the typical response was to shovel money into banks and hope for the best. Bank failure calls for quick resolution. Current approaches preclude that possibility. Thus far, there isn’t much evidence of genius or courage.

Anything else?

There are plenty of ideas floating around. A banking crises starts with cheap credit. Former Federal Reserve Chairman Alan Greenspan’s response to every problem was to make money cheaper. Without him, banks wouldn’t have had the money to lend foolishly in the first place (see The Greenspan putsch). Central bankers could have a look in the mirror.

Many commentators call for special regulations on banker remuneration, suggesting that the short-term bonus culture encourages risk taking but leaves those risks to be carried by someone else down the track. Again, legislation is better simple than complex. Instead of new complex legislation for bankers, why not simply tax the incredibly rich more? Many are bankers anyway.

Some propose addressing the problem of ‘too big to fail’ by breaking the banks up into smaller entities. Others suggest that the investment banking industry went bad when partnerships were dissolved and they became public companies. Returning them to their original form would mean they’re betting with their own money, not someone else’s, and therefore less prone to excessive risk. These are nice ideas in theory but difficult to execute in practice.

As for regulators, it would help if those charged with overseeing the banks weren’t previously employed by them. The revolving door should be shut. Much the same goes for the political system: Banks have enormous lobbying power. If political parties couldn’t raise money from them, we’d stand a better chance of getting the regulations we need.

Perhaps one of the biggest problems is the one most discussed at the time of the GFC and one we don’t hear much about now—moral hazard. Now that banks know governments will bail them out, they’re even more inclined to take bigger risks.

So it could happen again?

Of course, even with a legislative response that was both courageous and sprinkled with genius. We can only lower the probability of a systemic collapse, not eliminate the risk altogether. Dodd-Frank and Basel III might lower that probability a bit, but not by enough.

What are the implications for my portfolio?

Usual rules apply. Don’t have more than 10% of your portfolio in bank shares, including all the hybrids like ANZ CPS3 and CBA PERLS IV.

If you own insurance stocks and other financial companies, make sure the grand total does not exceed more than 25% of your total portfolio.

If you have been relying on bank shares for income and think you can’t afford to sell down, check out our income portfolio and read Bank shares versus bank hybrids from our sister publication Intelligent Investor Super Advisor.

Structuring your portfolio this way isn’t about being scared of what might happen—it very well may not—but planning for the possibility of it.