THUS Magazine

Zombie bankers announcing RBS latest results and having a larf at us

The financial system as a whole is rotten. Predicated on the now-doghoused dogma that markets know best and light-touch regulation is all that’s needed to produce the best of all possible worlds, the regulatory structure failed to prevent banks, insurers and investment funds from acting recklessly. During the good times, investors as well as managers made out like bandits, but when the chickens came home to roost, management had banked its bonuses and taxpayers were left holding the baby. By Chris Gilchrist.

The public is getting cross. They can see that Sir James Crosby, thrown over the side by the Financial Services Authority (FSA) when his role in the destruction of HBOS became a little too public, is an all-too-rare case of a disaster-causing and overpaid manager being denied his place alongside scores of Sir Wishdoshs on the City gravy train. What with this and continuing uncertainty over whether the hundreds of billions that have been thrown at the banks will sort them out, it’s clear we’re still in an almighty stinky mess. The key to sorting out the banks was recognized by analysts of Japan’s banking bust several years ago. You have to remove the toxic assets so that banks can function normally. Either you do this by dumping all the toxic stuff in a bad bank or you leave it with the existing banks and start new ‘good banks’. Solutions along these lines are being proposed by the likes of:

George Soros: http://online.wsj.com/article/SB123371182830346215.html  

Joseph Stiglitz: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4424418/Let-banks-fail-says-Nobel-economist-Joseph-Stiglitz.html

Paul Romer: http://online.wsj.com/article/SB123388681675555343.html
Willem Buiter: http://blogs.ft.com/maverecon/2009/02/good-banknew-bank-vs-bad-bank-a-rare-example-of-a-no-brainer/

They deal with part one of the problem – toxic assets clog up the system and prevent banks from lending, leading to the ‘zombie bank‘ problem that plagued Japan for years. Remove the toxic sludge and credit can flow again. But then you have to move on to part two: what type of new, good banks do we want? It certainly isn’t ‘Son of RBS’ or ‘HBOS2′. (THUS passim as far back in the mists of time as November 30!). One good reason for not re-creating these banks is that it’s simply impossible for outsiders to understand how much risk lies where inside a large cross-border multi-function bank such as RBS. It’s just too easy to transfer risk from one corner of the business to another, or to time-shift it, or to make it seem as if it’s been removed from the books when it’s only been removed from the books that regulators see. Over many years, national bank regulators worked together to produce new international bank regulations. Basel II was the recently-introduced set of guidelines that allowed banks to assess the level of risk in the riskier parts of their operations using models approved by regulators. This enabled them to self-assess their capital needs as lower than they should have been, thus adding to leverage and compounding distress into disaster. Regulators just added fuel to the flames.

So we need a different set of banks, each subject to a different form of regulation based on their level of risk. For example, chopping the new monster Lloyds-HBOS into three wouldn’t be difficult. Halifax could be a mortgage bank, the lowest-risk, must-work part. It could take deposits and lend on residential (not commercial) mortgages. It could ‘securitise’ mortgages, but only if it retained a chunk of the risk itself. It could sell insurance, but not be an insurer. Such ‘mortgage banks’ exist all over the world, don’t need a big capital base, are easy to regulate and they only get into trouble when regulators go to sleep at the wheel and let them do things they should not have done (as in the Savings & Loan disaster in the US in the 1980s). Part two would be Lloyds Bank of Scotland, a commercial bank offering business loans and finance. And part three would be Lloyds Capital, engaged in merchant/investment banking and rocket finance.
Both mortgage banks and commercial banks would have their deposits insured and ultimately underwritten by taxpayers, but their bondholders and other creditors would have no such protection. Merchant or investment banks would carry no guarantees whatever, and would be required by law to insure with a third party against certain categories of risk. A fund shared/guaranteed by sovereign nations might have to be the underwriter of last resort for certain types of financial disaster insurance, but if an appropriate insurance premium was paid in advance, leaving taxpayers on the hook for such risk would be acceptable.
A major change in banking regulation and structure on these lines would be workable but is being opposed by all the financial system insiders. Bankers oppose it because they can make money free riding on taxpayer support. Regulators oppose it because it will prove they have dismally failed and because the harder the task of regulation is, the bigger their organisations and salaries. Most politicians oppose it because the first two groups buy them lunch, and because taking a lead like this requires political leadership, making it uncomfortably clear that politicians are responsible – as indeed they ultimately are for the credit crisis.
In the first stages of the crisis, it was possible to believe we wouldn’t make the same mistakes as the Japanese did ten years ago in their own banking crisis. But the US, UK and Europe are making the same mistakes (the failure to scour toxic assets out of the system early is now acknowledged as the worst of all Japan’s bad policy decisions), and for the same bad reasons.

If we don’t see quick action to resolve the toxic debt issue, all the Western economies will have to endure years of misery like Japan’s ‘lost decade’ – complete with zombie banks. As RBS prepares to announce the biggest loss in UK corporate history – £28 billion, having consumed over £20 billion of public money in 8 heady months – we should all be very afraid, but not to afraid to act.