Europe's moment of truth  

The Business Spectator has a few unconventional rants about the teetering European financial system . I wonder when it will once again become conventional wisdom that keeping commercial banking and investment banking separate is kind of a good idea.

First Robert Gottliebsen floats the radical idea that voters should be consulted about bank bailouts and austerity plans (as well as creating a federal European government or effectively abandoning the idea of a continent wide currency) - Europe's moment of truth.

The current orthodoxy among world politicians is that voters should not be trusted to make a decision and that only on rare occasions should voters be told the truth. Papandreou, whose family has been involved in Greek politics for three generations, this week suddenly woke up that the only way Greece can implement the austerity program that the other Europeans leaders are demanding is that the voters agree with it and are told the truth.

What a breath of fresh air.

Papandreou is under huge pressure to go back to concealing the truth and not letting voters decide. But the world will be a better place if he holds his ground.

Here are three other ‘truths’ that should be flushed out:

– The big French and German banks have lost their capital (and a lot more) and need massive capital raisings plus government money to restore solvency. Voters are entitled to decide whether it is worth saving them. My guess is that the cost of not saving them is much higher than saving them. Yet given the banks broke every rule in the banking book, they do not deserve saving and shareholders of companies that lose their capital normally get very little.

– Italy, Spain and Portugal have deep problems. Their voters have every right to be told the truth and to decide which way to go.

– In the US the massive money printing exercise went into the pockets of the major global banks that used it to fund global speculation when they should have used it to lend for housing and business development. The US politicians need to have the courage to tell the people that these banks fund both parties so it’s hard to take action against them by separating their gambling activities from traditional banking.

Back to Greece: Papandreou is under huge pressure to reverse his referendum decision, but once he has announced a referendum it will be impossible to implement the austerity program without it. There is a good chance the austerity program will win voter support if the Greeks are told the truth that they must choose between the horrible immediate consequences of a balanced budget (about a quarter to half of the public servants may lose their jobs) and the austerity program where the Europeans are still pumping money in.

There are only two long-term solutions to the European problem – a movement towards a United States of Europe or alternatively a situation where countries that do not want to (or can’t) make the financial sacrifices leave the euro currency (or a perhaps the euro is left to the weak countries and the strong ones go their own way).

Voters must be part of those decisions or they can’t be implemented.

The debt crisis in Europe is the fault of bankers, yet the people are the ones who pay. The current mess is simply yet another earth-shaking collision between those who reap the returns from banking (shareholders and management) and those who bear the risks (everyone else). …

Andrew Haldane, the executive director of the Bank of England in charge of financial stability, gave a speech recently in which he showed as clearly as I have ever seen how the changes to banking over 200 years have contributed to the crises we have endured since 2007.

His last paragraph sums it up: “the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately. That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source."

Haldane explains that in the first half of the 19th century, when banking still existed in its original form, the capital put in by the owners of banks usually matched the amount of deposits – that is, bank gearing was 50/50.

Not only that, there was no such thing as limited liability as we have today: liability was unlimited and directors had the power to vet share transfers to ensure that the new owners had sufficiently deep pockets. As Andrew Haldane said: “This put shareholders firmly on the hook, a hook they then used to hold in check managers."

But during the industrial revolution, countries became hungry for more capital. The supply of credit was restricted by unlimited liability on bank shareholders, so it was progressively removed by governments, starting with Connecticut and Massachusetts in the United States in 1817 and concluding with the Companies Act of 1879 in Britain.

Shareholder vetting remained at first, and although liability was limited, a pool of uncalled capital was created that could be called on in an emergency – a sort of hybrid unlimited liability. That seemed like a good idea, but of course managers found that the act of calling on that capital merely worsened a crisis.

It was the first example of what Haldane calls the “time-inconsistency problem". That is, bankers do not exercise their available capital insurance because they fear – rightly – it would make a bad liquidity situation worse. The issue becomes even more acute when an institution is “too big to fail".

Eventually, the vetting of bank shareholders was dropped as well and “ownership and control were amicably divorced", as Haldane puts it.

The controllers (managers) soon learnt that taking bigger and bigger risks increased their returns without increasing the risks either to them or their shareholders. As a result, the ratio of bank assets to GDP all over the world has risen exponentially.

There was another incentive to increase bank gearing – tax. Interest on debt is tax-deductible but dividends paid to the providers of equity are not.

Moreover, managers are paid bonuses according to returns on equity, not on the returns they make on the total assets they manage.

Andrew Haldane suggests switching banker remuneration from ROE to ROA (return on assets). “Imagine if the chief executives of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA. By 2007, their compensation would not have grown tenfold. Instead it would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times."

He also suggests that voting rights be extended to a wider set of stakeholders in the bank. For example, depositors could be given a vote, albeit a smaller one than shareholders.

“The advantage is that governance and control would then be distributed across the whole balance sheet. Some of the rent-seeking incentives of the equity-dictatorship model would be curbed."

At the very least, although Haldane does not mention this, banks should be forced to return to their basic function of taking deposits and making loans.

This is the core recommendation of Sir John Vickers’ Independent Commission on Banking. He said that basic banking should be structurally “ring-fenced" from the other activities, specifically proprietary trading. Naturally bankers are howling about this.

It is time for governments to listen to Haldane and Vickers and get on with radically reforming the way banks operate and bankers are rewarded, and they should not waste time discussing it with banks.