Four Ways to Solve the Banking Problem – 03/21/2023 – Martin Wolf

Banks are designed to break. And that’s what happens to them. Governments want them to be both safe places where the public can keep their money and businesses that seek profits and take risks. They are both regulated public services and risk-taking companies. Managers’ incentives incline them to take risks, just as the state’s incentives incline them to bail out the utility company when risk-taking causes it to explode. The result is costly instability.

If one thing is clear from the events of the past two weeks, it is that the much-vaunted reforms introduced after the global financial crisis have not changed that situation all that much, or at least not enough.

Yes, the leverage of banking systems has dropped since the crisis. But it remains dangerously high. According to the Federal Reserve (Fed), the central bank of the United States, on March 8, 2023, the difference between the book value of assets and debt liabilities of US commercial banks was US$ 2.137 trillion. That portion of equity-backed assets had a hypothetical value of $22.8 trillion. But a recent document suggests that market losses are already around $2 trillion. A general bank run would expose these losses and wipe out capital. To prevent this from happening, the authorities would have to guarantee all deposits.

Kind words were spoken about the need for an orderly resolution of bank failures, and the need for equity capital to be first in line for loss. But, in the nick of time, that is not what happened in the Credit Suisse rescue operation. Shareholders retained value and the state also indirectly provided them with guarantees by guaranteeing UBS. However, the Swiss finance minister told us that “this is not a bailout. This is a commercial solution.” The truth is that it was a rescue. And perhaps it proves to be the least expensive solution overall. But this is not how the regime created to manage post-2008 crises should have worked. And I’m not really surprised by that.

At the current stage, it is still unclear how severe the crisis will be. But it is already clear that the reforms carried out after the last crisis, while better than nothing, were not enough, especially after the Trump administration tampered with them. They did not guarantee a crisis-proof system. They have not provided a smooth way to resolve a bank in crisis, especially if the crisis risks becoming systemic.

So what could be done? There are four general approaches to reform.

The first would be to let the market prevail, as Ken Griffin of the Citadel investment group argues. Unfortunately, the banks’ functions in providing money and credit are too vital to allow for this. The concept that government guarantees of deposits create moral hazard is also complicated. Depositors are unable to monitor the soundness of banks in real time: the absence of insurance would only unnerve them further. But the existence of the guarantee is clearly a subsidy to shareholders and thus encourages greater leverage and banks to take greater risks.

Second, strengthen current regulations. All banks whose deposits are safe, in theory or in practice, need to be regulated in the same way in terms of capital strength and liquidity. The decision to remove Silicon Valley Bank from the regulatory grid that encompasses systemically significant banks was a mistake, because anything can trigger a panic if a large enough number of banks have similar vulnerabilities.

Furthermore, at the same time that deposit guarantees are extended, insurance premiums need to rise, and be linked to banks’ risk characteristics, such as leverage. Stress tests need to go back to being universal, and brutally realistic about all risks, including interest rate risks.

Third, it is necessary to go far beyond the usual measures to reinforce the robustness of banks. One recommendation was to adopt a maximum leverage of three to one, compared to the 10 or 20 to one that is common today. An alternative proposal is to force banks to be funded by debt securities that automatically convert to equity securities as the firm’s market value declines. The above ideas would need to be accompanied by rigorous market value accounting.

One proposal by Mervyn King, former governor of the Bank of England, is for banks to match their deposits with their liquid assets. The latter would include a predetermined amount of collateral against loans obtained from lenders of last resort. This should guarantee liquidity at all times. Finally, managers of failed banks should be penalized, to reflect the reality that banks are utility companies.

A fourth idea would be to abandon the attempt to combine cash supply and risky lending into a single type of business. This would have two complementary elements.

Liabilities to the public that are assumed to be perfectly liquid and redeemable at full value (“cash”) should be matched one-to-one with similar assets. This could be done by forcing intermediaries to hold central bank reserves or equally liquid government bonds. This is the famous “Chicago Plan”. But members of the public could also now hold money at the central bank directly, which was impossible when access to banks required branch networks; today, it would be possible for everyone to hold central bank digital currencies, which are perfectly safe, in any amount. This idea would make the central bank the monopoly purveyor of money in the economy. Management of the digital payment system could then be handed over to technology companies. Money created by central banks could be used to finance the government (replacing government bonds) or be invested in other ways.

Meanwhile, risk intermediation could be done by mutual funds, whose value would move with the market. Or, less radically, the intermediation could be done by banking institutions, but institutions financed by a mixture of stocks, bonds and time deposits, not demand deposits.

Nobody is ready for these last approaches, for now. But the second and third need to be part of the agenda. Banks were revealed as a part of the state that poses as if it were part of the private sector. They at the very least need to be much more robust. Ideally, they would be radically transformed.

Translated by Paulo Migliacci

PRESENT LINK: Did you like this text? Subscriber can release five free hits of any link per day. Just click the blue F below.