The current edifice of global financial regulation is premised on the belief that systemic risk comes from evil-doing bankers and the investors who enable their luxury living. To bring bankers back to a puritan code of conduct, new capital, liquidity, resolution and prudential standards are being quickly mobilized by global regulators and speedily implemented under the Dodd-Frank Act. These will create a mighty fortress of costly, complex and – in many instances – deserved new rules. But, all of these new mandates fight the last battle, where bankers and regulators did a good deal that should never have been allowed. Will all these rules stabilize finance in the next crisis? As the Japanese disaster so painfully shows, crises come not just from cunning financiers. They also derive from the Hand of God.
The most recent call for a fortress of immutable bank rules comes from the UK’s top regulator. We are loathe to tussle with Lord Turner, a man with a formidable intellect and daunting experience. Still, we think his Wednesday speech on next steps for global bank regulation will take us down a primrose path.
In his in-depth analysis backed by a few dozen slides, Lord Turner details why he doesn’t think Basel III goes far enough and how the next regulatory round – focused on systemic resolution – should conclude. He wants the Basel standards to go to a twenty percent minimum, resolution preplanning that ensures no taxpayer support ever and, in conjunction with all of this, bail-in debt and contingent-capital rules to put investor capital at extra risk. The latter requirement would appear to contradict the second one, as it would mandate a layer of investor risk ahead of taxpayer support that would be barred, but Lord Turner says he wants it all because he wants the new framework to be bullet-proof.
For the moment, we’ll take it on faith that Lord Turner’s three-pronged plan would achieve his goal without shutting down banking as we know it. We think it would force a fundamental strategic shift, converting banks into utilities, but we’ll let that pass for now.
Still more fundamental is the question of whether, even if Lord Turner got all he wants, would it work as he hopes? To put investors at risk in the event of systemic failure makes sense if systemic failure comes from factors that market discipline can avert. It makes no sense if systemic risk results from forces of nature as relentless as those ravaging Japan or from the deeds of man as evil as we saw them on 9/11.
To make investors take the fall for these challenges to banking would be, in essence, to mandate that banks structure themselves always to be immortal. This isn’t any more doable in banking than it is for humankind – banks too are at risk of assaults against them over which they have no control.
If investors know that the bank must die even if not by its own hand, they will flee at the first sign of trouble, instead of hanging with an institution until the immediate crisis fades and the pieces can be picked up. Under stress like that evident in Japan, investors would need to run for the hills, taking with them the resources that would otherwise sustain banks that, absent acute operational risk, are wholly viable institutions.
Thus, barring government intervention all the time under every circumstance may be rough justice deserved most of the time. But, when banks are brought low by forces outside their own – or, for that matter, anyone else’s control – this stringent standard creates a vicious circle. The more a bank struggles to recover, the less resources will be at hand to do so because investors must act to save themselves before a governmental agency strangles the bank. Systemic risk indeed.