Banking on bailouts

Banks and financial institutions are hard to regulate as most operate globally and are attracted to countries with the least regulation. Governments must, therefore, cooperate for effective regulation

JUST as war is too important a matter to be left to the generals, banking sector reforms and regulations are too important to be left to bank executives, bank-executivesturned-policymakers or those who pretend to understand the intricacies of modern-day finance. As Paul Volcker, the former Federal Reserve chairman, once said, the only useful recent banking innovation was the invention of the autmatic telling machine (ATM).


All else is gambling with other people’s money — stating with a bit of exaggeration, of course. Investment bankers and hedge fund managers played the most damaging role in bringing the world economy to the colossal financial meltdown from which the economies of Europe and the US have yet to recover. They should not have a say in how the financial sector should be regulated.


At the hearings of the Financial Crisis Enquiry Commission in the US, last week, the executives of the top American banks appeared clueless, or pretended to be, of what caused the financial meltdown. If pretending dumb is the price they have to pay to save themselves from financial liability, they were all most willing to do so.


One executive compared the financial crisis of last year to a natural disaster that nobody could have predicted. Another said that financial crises happen every five to seven years — so get used to them. Consult these gentlemen about how banks should be regulated and there will certainly be another man-made financial disaster in the next five years.


The primary aim of the banking and financial reform should be to prevent the next financial disaster from happening. Policymakers need to check the weak spots in the system and install checks and balances to strengthen them, and avoid any systemic failure. The regulators should ensure that no bank or financial institution should be allowed to be too big to fail. The ones that are too big already should be subjected to scrutiny so that taxpayers do not have to spend hundreds of billions of dollars to bail them out.


The most often expressed fear among opponents of banking regulation is that too much regulation will stifle growth. The issue is: whose growth? If it means, restraining the growth or even shrinking the size of the financial sector, that’s a desirable outcome. In the past half a century, in most rich countries, the financial sector has become too large for the real economy. According to a report in the Economist , relative to the size of the economy banks in the UK are 10 times bigger now than they were 40 years ago. In general, banking sectors in most rich countries are too big, and should be cut in size.


Sadly, the message that the financial sector appears to have taken from governmental bailouts in Europe and America is that banks do not have to fear about failures; governments will always bail them out no matter what is happening in the rest of the economy. Such an attitude makes the banking and financial industry even more callous and irresponsible, and the next disaster more likely than before.


In addition,to bring economies from recession, governments in rich countries have been pumping cheap money into their economies through the banking sector. In return, whenever they get a chance, banks just pass on the cheap credit they receive as higher bonuses to their employees, in organising retreats and buying private jets.


THE behavior of bank executives seems so excessive that it sometimes appears that while everyone else has suffered from the financial meltdown, bank executives have benefited from it. To avoid the next financial disaster, governments have to install policies that send the financial sector the message that bailouts will not be free in future.


In the US and in Europe governments are trying to figure out how to create automatic checks and balances in the system to ensure that the next financial crisis is avoided. So far attempts have been more serious in Europe than in the US. However, it appears that the democratic debacle in the recent senate elections in Massachusetts and unfavourable ratings of Obama in several recent public opinion polls have sent a message to the US president that he needs to take the business of banking regulations and reforms more seriously. Last week, Obama announced what he called ‘the Volcker rule’ to ban proprietary trading by commercial banks. Indeed, proprietary trading should be banned for all investment banks and financial institutions, who pose the threat of creating a systemic risk.


Last month, a number of legislators also proposed that the Glass-Steagall Act that limited the scope of banks’ operations should be reinstated. The Act was passed in 1932 in response to the banking crisis that triggered the Great Depression, and repealed in 1999 by a Republican Congress and signed by President Clinton.


The Obama administration has also proposed a tax on financial institutions called the ‘financial crisis responsibility fee.’ The tax is expected to raise $117 billion to cover the projected bailout losses. A long-term solution would be for governments to charge an insurance tax on banks — a fee for insurance against future bailouts. Most importantly, banks have to increase their capital so that the chances of failures are minimised.


In last week’s hearings of the Financial Crisis Enquiry Commission, bankers and legislators debated the issue of how big is too big for commercial banks. Bankers, of course, argued that the government should not impose any limit to the size of financial companies so long as there is a regulatory framework that ensures that the taxpayers do not bear the burden of a banking failure. However, even the smallest of the bank failure does not happen in isolation. It creates contagion effects that spread to other banks and then to the rest of the economy and the entire society. Thus to avoid failures, banks that appear too big should be banned from indulging in activities that would result in risks that can lead to systemic failures.


In today’s global economy banks and financial institutions are hard to regulate as most operate in many countries. They are most likely attracted to countries with least regulation. Thus governments have to cooperate for any effective regulation of the banking industry.


Source:- The Economic Times, Neeraj Kaushal