Banks behaved irresponsibly in the late nineties and the early part of this century , and by their irresponsibility put the whole world at risk in 2008. True or false?
I will argue three things in this article. Firstly, that the behaviour of many banks was stupid and reprehensible but easily explained. Secondly, that this behaviour of some banks was predictable, was anticipated and was an entirely excusable reaction to the incentives the governments had created. Thirdly, that it was the behaviour of governments at the time and since which was really stupid, counter-productive and has put the world’s financial system at risk of melt down.
The easy bit is to identify, with the benefit of hindsight, the mistakes of the banks. Egged on by accountants they had enthusiastically sold their balance sheets for ever decreasing amounts of money to take ever increasing risk. Much of this was transferred off their balance sheets into financing vehicles (SPV). Because, with the encouragement of regulators and accountants they could pretend they had no liability for SPVs, their capital strength was hugely flattered. Whether it was property lending or sub-prime mortgages, ever decreasing margins or even dodgier credits varied between banks but the common factor leading them to perdition was the imposition under the guise of creating a level playing field of very specific detailed regulatory constraints on assets (which for banks approximately equates to lending and most importantly doing this in the same way in every major international banking location. Of course no amount of detailed regulation forced the banks to behave like Gadarene Swine – but it was a predictable (and predicted) reaction to enforcing uniformity of solvency and accounting rules that all banks would make the same mistakes at the same time as they would have the same experts telling them to react to the regulatory environment in the same way. So when one made massive ‘profits’ by funding SPV at low cost to buy high yield assets off balance sheet they all did. The pursuit of illusory profits (not to mention real bonuses based on the imaginary profits) made them forget Mark Twain’s eternally sound advice that one should be more interested in the return of ones’ principal than the return on the principal.
So the first part of the statement is absolutely true – banks behaved stupidly in the early years of this century – they believed that the profits they were making were real when they were not. But this is nothing new, as long as there have been banks they periodically swing from caution to excess and find creative ways of losing their shirts; most often based around inflated property values induced by their own activity. There are so many historical instances that there is no space to record them here but 1972 and 1992 were recent UK instances. Ironically one of the star players in each were local authorities, ranging from Cambridge to the Highlands and Islands, and Government Departments including the Audit Commission. It is not normally foolish old ladies who are gullible and place money with fast talking flashy banks offering unbelievably good interest rates as much as their elected representatives: Kent £50m; Norfolk £32m; Cambridge £9m; (and in case you think it is only a blinkered local government accountant who can be so silly, Oxford University £30m) were among the depositors with Icelandic banks named by the BBC in 2008. Little old ladies are more difficult to part from their money than bureaucrats from our money.
But was it this stupidity that put the world at risk, if the world was indeed at risk?
The lemming like tendency of banks to rush together over some financial cliff is one of the first things which any economic historian learns. Every few years banks have a cycle of prudence and difficult credit being gradually succeeded by easier lending, growing profits leading to increased competition and to lending to ever worse borrowers. When the music stops banks go bust, credit tightens and the cycle renews itself. Because such fluctuations do not occur in a vacuum but have (sometimes severe) consequences on the money supply and therefore economic activity, governments have for some time tried to intervene to reduce the fluctuations. There are two significant problems with this. The first is the knowledge that governments will intervene removes market discipline. So if you know you will be protected from bankruptcy, why not deposit with Icelandic banks for an extra few per cent even though they are clearly over extruded? The second is that when banks are going bust the government will try hard to save them and the only easy way is to persuade other banks to take them over (so Lloyds was pressured into buying Bank of Scotland, etc.). Successive rounds of crisis in the UK (1972, 1992 and 2008) led to fewer banks. The bigger the bank the easier it is to regulate or suborn, and the more complex and detailed the regulation the greater the economies of scale in meeting the requirements. But there is more. Foolish behaviour is unpunished – when Co-op Bank was persuaded to take over a failing bad debt riddled Britannia Building Society who got to run the Bank? There is no managerial reward for caution. Nor is there the profit which should be there for wise bankers when foolish ones are bankrupted. And if by some chance those who ran their business prudently do make extra profits the government will probably invent a special levy to confiscate them. (Somewhat over £2bn a year under George Osborne). Or worse – both in the USA and the UK banks who acceded to the urgent request of the authorities to rescue their foolish competitors have been subjected to massive fines (JP Morgan fined $13bn) for activities of those they rescued which took place prior to the rescue. But the banks do not complain because their boards and executives would be much worse off if there were true competition in the banking industry. The fact is that a cosy cartel suits both governments and banks; the only people who suffer are taxpayers, businesses and future generations.
By 2008 OECD governments had brought about a situation where all their major banks were more similar in their balance sheets than ever before. They had encouraged the view that boom and bust had been abolished and had implicitly promised they would write out huge cheques to any bank in difficulties. The crisis was indeed waiting to happen – but the reason it was so close to doomsday for financial markets was simply that when governments were needed to write out cheques their credit had gone. A banking crisis should be followed by a government bail out in the world of cosy cartels. But that requires governmental credit to be good and when financial markets saw the size of the bills they quickly appreciated that in the words of Liam Byrne the Chief Secretary to the Treasury of the last Labour Government “I am afraid there is no money left.” Quite simply, the rule that deficits in downturn should be followed by a surplus when the economy recovers had been comprehensively flouted. Deficits everywhere had ballooned, and the prospect of huge additions to government debt was met with horror by all financial markets. And it was this lack of credibility which threatened a breakdown of the financial system. It was patently obvious to all that Iceland with a GDP under $10 bn could not bail out banks with liabilities of $50bn and clearly Greece, Spain, Ireland and Portugal came under the same sort of classification. Even in the USA and the UK there were those who doubted whether the credit rating of the Government would stand up to the demands of bailing out the New York and Edinburgh banks, so large was their existing debt.
It was therefore not the banks, not the bad debts or stupid laxity in lending and absolutely not the lack of regulation which made a perfectly normal financial crash into a worldwide crisis; it was the failure of governments to control their own borrowing which meant they were incapable of calming down the markets. A lender of last resort must have total credibility and they had lost that. This added to their previous actions to remove competition which had made banks so large that their failure was too horrible to contemplate, and the introduction of the Basel Accords which led to the same problems in every major international banking sector happening simultaneously. Taken together, the failure to control their own balance sheets and the eagerness to control banks’ balance sheets almost led to financial meltdown. That is the truth of 2008. The scary thing is that today governments are still running immense and unsustainable deficits; they are still encouraging ever larger banks and they still promulgate ever more complex rules rather than putting in place a fiscal and regulatory regime which would promote competition and smaller banks. Until they do this we will be condemned to ever worse crises and a continued risk that next time the UK will not be able to survive them.