Vickers is not enough to stop another Libor scandal

From Financial Times
By Laurence Kotlikoff
July 9, 2012

In response to the latest banking scandal – Barclays’ rigging of Libor rates – David Cameron is calling for better banking culture. Good luck with that. What the prime minister should do is rethink the feckless reforms of the Independent Commission on Banking. This is a throwback to the Glass-Steagall Act, which prompts much nostalgia, but will not and cannot keep banking safe, as the eurozone crisis shows.

The commission was charged with keeping the still-reeling UK economy safe from its banking system. It has done nothing of the kind. Instead the commission plays lip service to real reform with its call to ringfence banks’ retail operations. The government is blithely adopting the commission’s recommendations. Instead it should replace them with what I call Limited Purpose Banking, where banks stick to their core roles: mediating the payments system and connecting lenders to borrowers.

The history of bank failures is a sorry record of promises that cannot be kept for legitimate reasons as well as fraud. But, unlike standard bankruptcies, bank failures have far greater economic fallout. Banks not only market financial products, they also make financial markets. Markets, be they for apples or loans, constitute critical public goods whose provision should not be jeopardised. The financial market is particularly fragile, and yet the Vickers commission, as it is known after its chairman, perpetuates faith-based casino banking and vast leverage.

The Vickers report discusses neither the public goods aspect of banking nor why banking requires special regulation. It also fails to identify the root causes of the financial crisis – opacity and leverage. Markets do not operate well in the dark. When people cannot tell what they are buying, the slightest evidence of misrepresentation or fraud can trigger a run.

In 1982 several bottles of Tylenol in Chicago pharmacies were laced with cyanide and sold to unsuspecting customers, who promptly died. News of the deaths quickly rendered worthless 31m Tylenol bottles across the world. To prevent further losses, Johnson & Johnson repackaged new Tylenol in safety-sealed containers. This was an act of disclosure, since customers were now assured the bottles contained only Tylenol shipped from the company.

No such disclosure occurs in banking. And so fraud, suspicions of fraud, or suspicions of suspicions of fraud can spark bank runs. Those who run first are short-term creditors induced to lend with the promise of quick escape if they smell something rotten. Other creditors escape as soon as possible. The greater the borrowing, the faster the run, since to the swift go the spoils. Thus opacity and leverage are not only the sine qua non for bank failure, they are the catalyst.

Instead of restricting leverage and enforcing disclosure, the Vickers report rearranges the proverbial deck chairs by ringfencing “good” banks. Under the commission’s plan, good banks hold good assets (eg “safe” mortgages and sovereign bonds), have only good customers (eg retail depositors, and small and medium- sized enterprises), and do only good things (ie no proprietary trading or transacting in derivatives). Good banks are also closely monitored and bailed out as needed.

“Bad” banks are the investment banks and other “shadow/shady” financial corporations. Bad banks have bad customers – large corporations, foreigners and other bad banks. They hold bad assets such as derivatives, engage in bad practices and should not expect government rescue. Both good and bad banks retain more capital against “risky” assets, submit to stress tests and make their longer-term debt loss-absorbing to speed up financial funerals. Unfortunately, good assets go bad. Spanish and other eurozone periphery junk bonds used to be top rated. So did Lehman and AIG bonds, and top tranches of bundled subprime mortgages.

Today, gilts are ultra “safe” assets. But, given the UK’s long-term fiscal position, gilts are very risky. Yet the commission would allow good, ringfenced banks to borrow £25 for every pound of equity and invest it all in gilts. In this case, the commission’s ringfenced banks would fail if gilt prices dropped by just 4 per cent.

The commission’s higher capital requirements would not help, since they pertain to “risky” assets. Furthermore, its capital requirements are lower than Lehman’s reported capital level three days before it failed – a report its regulator apparently approved.

When trust takes a holiday, creditors find no comfort in capital ratios. The banks’ opacity makes it impossible to verify if their capital ratios are as high as advertised. Finally, in suggesting that bad banks will be left to sink or swim, the commission raises the risk of financial collapse in times of crisis. If the bad banks’ bad customers actually believe the commission’s intimations that their credits will not be honoured, they will exit at the first sign of trouble. As a result, the instability of the bad banks and the entire financial system will increase.

For all the good intentions and hard work of its members, the commission protects neither good nor bad banks. Nor does it protect the public from the failure of opaque, leveraged banking. What the commission protects are the bankers, who, apparently, are too big to cross.

The writer is a Boston University economist. His new book is ‘The Economic Consequences of the Vickers Commission’

Read the full article at (subscription required).