Evercore Pan Asset

The Deputy Governor of the Bank of England said last week that for capitalism to work large banks had to be allowed to fail if they made serious mistakes. He argued that if bank shareholders and senior executives make money in the good times, it should be those self same venturers who lose money in the bad times.

The Bank was rightly worried about “moral  hazard” at the start of the Credit Crunch in 2008.  Its scruples were soon overwhelmed by government policy and the fashion of the age to pump large sums of public money into weak banks, to shore up their capital and to meet their liquidity requirements. Those of us who suggested a different approach at the time were told we were wrong. It is good to see new thinking from the authorities.

The main reason we need a better way of handling future bank crises is a very practical one. If you simply transfer too much of the banking sector’s risk to the public sector, you weaken the balance sheet of the state. The most worrying feature of the Icelandic and Irish crises has been the way that the state’s creditworthiness and ability to pay for its own legitimate spending can be severely compromised if the state has guaranteed too many bad debts and underwritten too large a collective banking balance sheet. At the base of the worries about other sovereign debt in Euroland lies concerns that other EU states have taken on too much banking risk for comfort.

So what were the other options in 2008-9 that the authorities then spurned?  In the dangerous climate of the Credit Crunch it was sensible that the leading governments wished to reassure depositors. Deposit insurance was in place in many cases. In some cases it needed strengthening, and has usually been so since. Allowing the wipe out of depositors at some leading banks would have caused even more frantic attacks upon the whole banking system, and made commerce and trade even more difficult to conduct.  It was not necessarily sensible to conclude that large sums of new capital had to be subscribed by taxpayers to save the banks in the form they had reached.

Instead Central Banks could have performed their duty as lenders of last resort to help a bank in immediate trouble as the bank borrowing markets froze. The loans could have been time limited. Each bank needing the money could  have  been  required to produce a plan to ensure the orderly reduction of its activities, the sale of subsidiaries, the winding up of books of financial instruments, a plausible profile for cutting its overall loan risks, and plans to cut costs sharply to get back into profit. If this process of drastic slimming led to permanent losses they would be at the cost of the shareholders and junior bondholders of each bank.

What are the options in future? The best option is to so regulate banks that large ones do not get into the same difficulty as some did in 2008-9. The Deputy Governor says the answer is to make them hold even more capital. They are already holding considerably more than at the worst stage of the crisis. As the economies affected need some growth to improve public and private finances, the Bank needs to be careful how quickly it imposes much tougher new rules. The Deputy Governor is correct to say that in future it needs to be counter cyclical in its regulation. It should of course demand more capital be held when assets prices are rising rapidly and when loan books are expanding speedily. That is scarcely the present situation.

One of the reasons we had such a violent cycle between 2005 and 2010 was the failure of the Monetary Policy Committee of the Bank of England to read the cycle well and set the right interest rates at the right time. Low interest rates and easy money fuelled the boom. Higher rates and scarce money brought on the bust. I hope the new Bank, and its measured Deputy Governor newly responsible for bank regulation, has a clearer view of where we are in the cycle. Success at counter cyclical regulation requires cool judgements. An excess of prudence near the bottom can be as worrying as an excess of high spirits near the top of a boom.

As published in Investment Week