A message for G20 leaders considering banks too big to fail

Too big to fail, or too big to jail? Mike Chaput/Flickr, CC BY-NC-SA

The global financial crisis had many causes. But it was generally acknowledged at the time and since, that failures of ethics, integrity and trust were an important part of the problem.

US Republican Senator Tom Coburn, part of a bipartisan senate investigation into the meltdown, said:

“It shows without a doubt that lack of ethics in some of our financial institutions who embraced known conflicts of interest to accomplish wealth for themselves, not caring about the outcome for their customers.”

Financial scandals have continued, from Libor and currency manipulation, to conflicted advice in wealth management - where advisers managed to transfer a good deal of the wealth managed into the manager’s wealth.

This year, IMF managing director Christine Lagarde reminded us that:

“Trust is the lifeblood of the modern business economy. We need a stronger and systematic ethical dimension … the link is clear - ethical behaviour is a major dimension of financial stability.”

Too big to fail

Anyone talking about financial integrity is bound to talk about the moral hazard of “too big to fail”.

My father once explained bank runs in the simple terms a 13-year old could understand. Governments save banks from bank runs not because the bank has been well managed. If the bank had been well managed, there would have been no run. Banks are saved for the sake of the economy. But you don’t save the bank board and you don’t save the shareholders.

However big the bank is, if it has to call for a bailout, the board and senior management have failed – and failed to earn a bonus. The shareholders are looking at a failed investment. Somebody else should be running the bank and more share capital has to be found.

The price at which that capital can be found may mean a massive write-down or total wipe-out of existing capital. This is how banks treat insolvent clients. There is no reason for special treatment of bank boards, managers and shareholders – and any such treatment would distort the efficient allocation of capital.

There is, of course, a difference between a temporary cash-flow problem and problem that goes to long-term viability. But if cash is lent to cover the former, it is at a higher interest rate (not 2.9% as in Australia) and takes precedence over all other debt and equity. The shareholders lose first, the existing debt holders next and the government bail-out funds last.

As to size, the bigger the bank, the more incompetent or avaricious bankers have to be to get it into this kind of trouble. This leads to the rhyming epithet of “too big to jail”.

Banks have been fined a quarter of a trillion dollars by US agencies alone. But where are the jailbirds in one of the Western world’s most retributive societies? Bankers are negotiating higher fines in return for not being prosecuted – an interesting conflict of interest.

‘Conflicted policy advice’?

Not only has the normal retribution for failed management been remarkably restrained, but financial institutions seem to have been the recipients of remarkable generosity. Indeed, it sometimes seems as if the finance industry’s suggestion for every contingency is to give or guarantee more money to them even when they are a large part of the problem. Are we seeing a form of regulatory capture of financial regulation? (Or should we call it “deregulatory” capture?)

When banks press for policy responses, we should recognise they have a great deal of knowledge about the industry. But they also have a great interest in outcomes. This does not mean we should not listen to banks. But we should listen to them as salesmen rather than sages and seek other sources of advice to test the sales pitch.

When we turn to economists, we should prefer those whose theories recognised the likelihood of booms and busts (though those who have publicly acknowledged, analysed and learnt from their mistakes may have some very useful insights).

Is banking too large a part of our economy? Economist Paul Krugman points out it has risen from 4% to 8% of US GDP over the last 50 years. Does that mean the finance industry has a more important role, is less efficient or is a successful rent extractor?

By way of comparison, if lawyers’ income as a percentage of GDP doubled, would you assume that you had twice as much justice? And is the US healthier for spending almost twice as much of its GDP on health as comparable countries?

Should banking involve low risk, lower return?

Banks typically defend their level of profitability by saying it is similar to other industries. But is it reasonable to expect banks to have the same return on capital as other industries?

Banking involves lending on security. The bank gets paid out of its security first. All share capital is lost before the bank loses anything.

If the risk to a company that borrows is greater, and the risk to the bank is less, and if markets operate in the way they are supposed to operate, bank return on capital ought to be less. If not, the bank is either engaging in risky behaviour or oligopolistic rent seeking – or both. Contrary to what the ANZ’s Mike Smith insists, if banks are made safer, the investment is safer and the return should be less and there is no reason why banks should receive bigger margins from borrowers.

Should bankers be rewarded for risk taking (whether the risks are on the banks, their customers or the economy)? We do not want lawyers, doctors and engineers to take big risks – indeed we expect high standards of care and disbarment for negligence. Should we expect the same of banks/bankers – especially as some refer to themselves as “finance professionals”? But that is a matter for another time.

Last month, Griffith University hosted a “Global Integrity Summit” and financial integrity was one of the issues discussed. For background papers on this and other issues click here.