How to manage the gigantic financial cuckoo in our nest

A year ago, at the height of the financial panic, the world yearned for a profitable and confident financial sector. It now has what it wants, but hates it. As joblessness soars and the hopes of hundreds of millions of people are blighted, the financial sector’s survivors are thriving. Even bonuses are back. Policymakers have made a Faustian bargain. Success feels like failure.

Yet success it has been. The stock market capitalisation of banks has recovered, to an enormous extent (see charts). This does more than indicate confidence in the future of the banks; it also facilitates the capital-raising the banks must do, particularly, argues the International Monetary Fund’s Global Financial Stability Report, in the eurozone.

This recovery has been no accident. When central bank money is almost free, prices of risky assets are recovering and competitors have disappeared or are weakened, making money is a relatively simple matter for the strong survivors. With earnings recovering, can bonuses be far behind? Alas, no. According to a recent note from the London-based centre for economics and business research City bonuses will rise by 50 per cent this year, though will remain 40 cent below 2007 levels.

Yet few wish to take credit for this success. Policymakers hardly want to declare that, thanks to their efforts, the surviving bankers will be buying palaces, while humbler folk worry about their jobs and homes, and face decades of fiscal austerity. Watching financiers – beneficiaries of the most generous public rescue in history – returning to their old ways is the cause not so much of envy as sullen resentment. Why, many wonder, should the rigours of the market apply most brutally to those innocent of causing the catastrophe?

According to the IMF’s World Economic Outlook, the outlay of advanced economies on capital injections, asset purchases, guarantees and liquidity provision amounts to 30 per cent of gross domestic product. Moreover, most financial entities – weak and strong – have benefited from this largesse. As Mervyn King, governor of the Bank of England, noted in a speech on Tuesday, “to paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.

I remain of the view that the only thing worse than rescuing the system would have been not to do so. Even two redoubtable critics, Peter Boone of the London School of Economics and Simon Johnson of the Massachusetts Institute of Technology agreed, in a recent piece for The New Republic, that this was a decision we “had to make”. But such an exercise of sovereign power on behalf of a single industry has consequences. Adopting “never again” as a watchword must be among them. In truth, many governments may find it impossible to do this again, since they may reach the limits of creditworthiness.

As Lawrence Summers, President Barack Obama’s principal economic adviser has insisted, we have been more than adequately warned. In a speech last week, he noted that “roughly every three years for the last generation a financial system that was intended to manage, distribute, and control risk has, in fact, been the source of risk – with devastating consequences for workers, consumers, and taxpayers.”

Predictably, many in the industry are fighting regulation as hard as they can. In an interview with the FT, Marcus Agius, chairman of Barclays, indicates perfectly what the backers of regulation are up against. His attack starts by insisting upon a “level playing field” across jurisdictions. He also argues against excessive capital requirements, since “the next time the banking system wants capital, it won’t be supplied [if] the potential new investors [don’t] see the [attraction]”. Moreover, “one of the other consequences will be that credit will become more expensive and [that] is not conducive to a return to economic growth around the world.” He also insists that “banks should not be vilified for taking risks”.

All this is quite unconvincing.

According to the IMF, writedowns on UK bank assets are going to be $604bn, against $814bn for the eurozone and $1,025bn for the US. Yet the US economy is roughly six times as large as the UK’s. The UK’s cuckoos are too big. Regulation must take these differences into account.

Again, the argument that the banks will be unable to raise capital if returns are depressed reverses the logic: the only reason banks have to raise so much capital is that they took on too much risk in pursuit of unsustainably high returns. Yes, credit is likely to become more expensive, with higher capital requirements. But credit supply was excessive and needs to be curbed.

Finally, as Mr King stresses, banks that are too big or important to fail cannot be expected to manage risk wisely. As he notes: “It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.” In a market economy, the taking of risk is disciplined by bankruptcy, not underpinned by taxpayers.

Imposing either a “windfall tax” or special curbs on bonuses is an understandable political response to what is happening. But since the aim of current policy has been to transfer money to banks, what is the point of taking it back again? Again, while undercapitalised institutions should not pay dividends or discretionary bonuses, until they have reached their targets, do we wish to see permanent controls on levels of pay? The issue is whether incentives encourage excessive risk taking. That is where regulation should focus.

We must not get diverted by the financial sector’s opposition or by populist rage. We must focus, instead, on the core issue. Trying to make financial systems safer has made them more perilous. Today, as a result, neither market discipline nor regulation is effective. There is a danger, therefore, that this rescue will lead to still greater risk-taking and an even worse crisis at some point in the not too distant future.

Either we impose a credible threat of bankruptcy, or institutions we have to support are made safer, or, better, we have both of these. Open-ended insurance of weakly regulated institutions that take complex gambles is intolerable. We dare not return to business as usual. It is as simple – and brutal – as that.

martin.wolf@ft.com
More columns at www.ft.com/martinwolf