There is an inexorable drive on both sides of the Atlantic to finalise new rules, regulations and laws to place the financial system on a sounder footing. But in their zeal to act, politicians and regulators are looking through the wrong end of the telescope. Too much attention is being paid to maintaining a status quo that allows banks to continue engaging in the full range of activities to which they have become accustomed – admittedly under a number of regulatory constraints – without dealing with the fundamental causes of today's critical difficulties.
Policymakers are intent on announcing all manner of new capital requirements, leverage ratios, “living wills” and directives on risk management, while brushing aside warnings by both Mervyn King, the governor of the Bank of England, and former US Federal Reserve chairman Paul Volcker that our banking system is unsound. Mr King and Mr Volcker are not alone in their concern that we may now miss a unique opportunity to secure core reforms.
The Basel Committee on Banking Supervision – the key multilateral authority on setting financial rules – dumped an 88-page present on governments and banks just before Christmas and, true to form, its focus was on technical ratios designed to force banking stability. The US House of Representatives last month voted for regulatory reform legislation that is no better. The House fails to consider the distinction between things that are critical and things that are merely important. The same mistake seems likely from the European Union, which is in the throes of establishing three new regulatory authorities.
The safety and soundness of the financial system is indisputably essential; without it, we have nothing. The long history of financial collapses proves this point. While efficiency, creativity and credit availability are important, they cannot be allowed to trump safety and soundness.
“Too big to fail” is the mantra of the day, but this mischaracterises the problem. The larger an institution, if soundly based, the more credit it can provide. What is of primary importance is the bank's combination of activities. This is a key question that needs to be asked. It is not addressed, for example, in the House's legislation or in the proposals sent to Congress by the Obama administration.
It is not too late to give centre stage to the question: should a bank's operations include activities that could create a combustible mix and threaten the system as a whole?
I believe it is unsound for banking institutions to have the right to go to the Federal Reserve while pursuing lines of business that could result in such a combustible mix. Formulas that restrain such volatile operations – as are now being put forward on both sides of the Atlantic – will lead only to endless definitional arguments between the regulators and the industry. It is delusional to think that a regulatory system can be based on formulas – either the investment bankers will outwit the regulators or the regulators will overreact.
The architects of the new laws and regulations have been so focused on the financial institutions that they have lost sight of individual depositors. Everyone, however, has a relationship with a bank, while the average person has no interaction with the so-called shadow financial institutions. That is why there are 220,000 people working at JPMorgan Chase and only 31,000 employees at Goldman Sachs. Banks are the one place where the ordinary citizen touches the financial system. That citizen wants to be certain that he or she is dealing with an institution that is safe and sound.
