Burgess COMMENTARY

Peter Burgess

Can we curb the capacity of banks to create crises? ... New rules and regulations are not enough to create a sustainable financial system ... The UK financial system remains fragile despite changes to regulation.

The UK financial system remains fragile despite changes to regulation. Photograph: Tom Archer/Barcroft Media

Sustainable finance may have soft edges – finance initiatives to support a clean environment, community development, small-scale business enterprises – but the hard core is about financial institutions that are safe, stable and don’t expose taxpayers to a recurrence of the great financial crisis of 2008–09.

Six years on, we have made some progress, but the financial system remains fragile, and in some respects unreformed.

Perhaps we should be more realistic and accept that recurring financial crises go back a long time. The economist J K Galbraith judged that they occur because, in every generation, the specious association is made between money and intelligence.

He observed that history counts for little in the finance world, and that “past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” This is a wonderful description of finance in the 2000s, and still today.

A lesser known but hugely insightful economist, Hyman Minsky, wrote at length about financial stability in the 1980s, convincing the few prepared to listen that recurring financial instability was endogenous to capitalism. He taught us how to spot it, and how to prevent it – but he was not optimistic that people would change their ways.

In the wake of the financial crisis western banks have had to sign up to new rules and regulations that require them to hold more capital, limit trading, reduce the proportion of loans to assets, and conform to more robust behavioural standards. Some have come into force already, some will come into effect in coming years.

Last year the UK parliament passed the Banking Reform Act, requiring banks to separate retail and investment banking activities by introducing a ringfence around the deposits of individuals and small and medium-sized businesses.

The US Congress has passed the Dodd-Frank Act, which includes new oversight and supervision, a framework for winding up large failing banks, new compliance and consumer finance laws, higher capital provisions for banks, and changes to corporate governance and executive compensation practices.

The Basel Committee on Banking Supervision, an international forum for bank regulation and supervision, has agreed new rules governing the adequacy of capital and liquidity in banks.

The Financial Stability Board, a global forum that monitors and makes recommendations about global finance, and chaired by the Bank of England’s Mark Carney, has also promoted new guidelines that define both how much and what type of capital banks should be required to hold so as to absorb losses.

These and other initiatives are mostly desirable, though the financial system remains fragile. The credit system isn’t working properly again, banks are still ‘too big to fail’, and we still couldn’t cope well with a systemic problem.

We’ve tried to make banks safer – while succumbing to lobbying pressure for dilutions and caveats – without trying to make the banking system safer. There’s a big difference between the two.

Instead, we could change the way the system works by restricting the extent to which banks create money, or in an extreme version, prohibit them from doing so altogether. Building societies didn’t create money in the way banks do, and are still managed to serve the community and make a return for shareholders.

We could require banks to hold substantially higher reserves or risk-free government bonds against their deposits, in effect curtailing their ability to use leverage and create money.

There are alternative and contentious ways of creating money in which the government and the central bank would do what the private sector has done until now.

If this is too extreme, then we should demand some increase in the backing for deposits, new fiscal rules to discourage banks from issuing debt, the maintenance of higher levels of capital than is now the case along with a higher proportion of what is called tangible, or loss-absorbing, equity, and a governance regime that would look to break up the largest, too-big-to-fail banks.

Investment banks do riskier business than high street banks, bringing borrowers and lenders together in capital markets and adding liquidity to the functioning of markets. But serial abuse of regulations going back several years has resulted in fines and criticisms about governance models and corporate culture. Since they comprise parts of modern universal banks, the call to see them broken up, separated formally from retail banks, and made to stand on their own is likely to continue.

Fortunately, a systemic financial crisis in advanced economies doesn’t look to be an imminent threat. But our economic predicament doesn’t allow us to rest easy. In the next five years another downturn or recession is likely – they tend to happen once a decade roughly. Then we will find out exactly how sustainable our finance system is.

George Magnus is the former chief economist of UBS and author of Uprising: will emerging markets shape or shake the world economy?

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