If a bank is too big to fail, it must be broken up

None of the planned banking reforms protects the financial system, argues Irwin Stelzer.

By Irwin Stelzer
Published: 6:17PM BST 28 Jul 2009
Comments 25

The message from the past few weeks is clear: abandon hope, all ye who thought the current crisis would lead to the radical economic reform that is so clearly needed.

Gordon Brown was never enthusiastic. For one thing, he sees himself as the heroic Prime Minister, with his fingers in the dyke, holding back a flood of bankruptcies and bank failures. Reform would eliminate the need for such heroics.

For another, radical reform would require an admission that the existing system, of which Mr Brown is the author, is seriously flawed. Better, according to the recent White Paper, to rearrange the deck chairs on HMS The City, to tweak a regulatory agency here and a rule there, than risk a terminal choke on the words: "I got it wrong."

So all eyes and hopes were focused earlier this month on the shadow chancellor, George Osborne. Previously, he had produced some sensible suggestions about how to reduce systemic risk and keep the financial system from meltdown. He was among the first to suggest that the capital requirements of banks be raised as lending increased, so their strength would rise with the risks they took on.

So far, so sensible. But it appears that Osborne, the radical reformer, had second thoughts about what should have been his signature discovery – if a bank is too big to fail, it is too big. And if it is too interconnected to fail, lest that failure bring down the system, then it is too interconnected. In short, break up banks that create systemic risk, and separate deposit-taking from other, more exotic activities.

Why he backed off is unclear. Yes, those novel activities are important if the financial services sector is to continue to find innovative ways of lowering the cost of capital, making capital and credit available to those shunned by more conventional lending institutions, and activating the animal spirits of entrepreneurs. But they are best conducted by firms of whom it can be said, "If they fail, they fail. A pity for their investors, no matter for the financial system."

In short, 'tis a pity that the Shadow Chancellor didn't follow up his important insight. Reforming the regulatory institutions will be of little use without fundamental reform of the structure of the financial institutions they are charged with regulating. He is, of course, right to seek a second-best solution: creating incentive systems that discourage the sort of behaviour that creates systemic risk. But that is rather like buying rubber gloves for a leaky fountain pen, rather than repairing the pen – or tossing it out and buying another.

We are left, as the politicians vanish on their holidays, with a situation in which no reformer, in either party, truly seems to understand the proper role of the Bank of England. It is not to regulate the institutions that constitute the financial system: it is to try to stabilise the macroeconomic environment by deploying such weapons as it has to tighten credit and the money supply when inflation threatens, and to ease when a recession hits.

This is no easy chore. For one thing, it requires an ability to forecast the near-term course of the economy, a task at which economists have not distinguished themselves of late. For another, it requires real independence from politicians, who generally are willing to risk inflation rather than take tough measures to contain it.

William McChesney Martin, the former chairman of the US Federal Reserve, famously said that it is the function of a central banker to "take away the punch bowl just when the party starts getting interesting". This role is more important than ever, for two reasons. First, the economy has experienced a period of what is politely called "quantitative easing" – expanding the money supply. At some point, that process will have to be reversed to keep all that extra money from pushing inflation to unacceptable levels.

Second, the nation's fiscal situation is dire: deficits are high, and rising, and showing no signs of coming down even when the recession ends. The Governor of the Bank of England will have to talk truth to power, and tell the next government that if it does not rein in the projected deficits, he will be forced as an offset to jack up interest rates to growth-stifling levels.

That is quite enough to ask of any central banker, without asking him also to regulate the goings-on in the securities markets and at individual banks, as Osborne apparently wants to do. Instead, he should figure out how to encourage communication between the FSA and the Bank of England, and revamp the FSA so that the firms it regulates are less fond of it (economists call such a love-in "regulatory capture").

And the Tories should certainly think again about setting up a special consumer-protection agency to deal with the financial sector. The consumers' ultimate protectors are competition and full disclosure, and the Office of Fair Trading, which currently has the remit, is the one agency that has demonstrated that it knows how to discharge its responsibilities, and could do so given an sufficient injection of resources.

As with medicine, so with regulation: the first rule is to do no harm. To impose new burdens on the central bank, and to preserve unchanged those institutions that are too big to fail, is to ignore that rule.

http://www.telegraph.co.uk/finance/5926 ... en-up.html