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How are the mighty fallen

Created:
15 October 2008
Written by:
Alistair Blair

How did we get to where we are? It is not solely the result of 'City greed', or of feeble regulation, nor even consumer naïvety. It is all of these things and more - and all of them will rear their ugly heads again. What follows are some thoughts on how these forces might be contained in future.

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Preliminaries

1. Bankers en masse are not uniquely bad, uniquely naïve or even uniquely greedy. Any economic sector which experienced the trends and new frontiers which have characterised banking over the last 25 years would have come to believe that its senior management were masters of the universe who should stick to their mission and were entitled to the rewards they generated.

2. When such trends prevail, "the crowd" sets the pace and it will never look over the edge - most people immersed in prosperity are incapable of doubting it. Some bankers knew a precipice lay ahead, but their opinions could never have changed the general direction. A tiny few voiced doubts. Even if those who remained silent had spoken, the warning would have been useless.

3. Banks are a powerful lobby. If enough of them want something, they will eventually get it. We wish governments would not give in to them so readily, but in vain.

4. Therefore, when the opportunity arises, the ratchet should be engaged seriously, so that it will take bankers a long time to get back to where they would naturally like to be.

5. Some banks, notably HSBC, JP Morgan and Santander, appear either to have sidestepped the crisis or not to have dabbled in its causal factors at all. However, we should fear these banks: first, because they are poised to become overwhelmingly powerful; secondly because they will not always be so cute - next time there's a disaster, there is no saying that whoever is in charge of them then won't have delivered them right into on the middle of it.

6. State control is not the answer. We should rely on regulation. The equity positions now being taken by governments should be sold down as soon as possible.

The amount of lending and the gearing ratio

7. Credit is good but too much credit is bad. Yet "too much credit" can seem to be good for a very long time - at least ten years in the current case. Moreover, "too much credit" is a situation that can only be recognised by a very few people, whose voices will always be drowned out by those enjoying the credit and those enjoying providing it. (These few predicted the Icelandic calamity five years ago. I recall reading a report sponsored by the Icelandic government entitled - something like - "Why Iceland banking is not a disaster waiting to happen". No-one was interested.)

8. For several years, UK banks (like most others) have been required to maintain about £6 of shareholder equity for every £100 of lending. As part of this week's resolution in the UK, banks are being forced to improve this ratio closer to £9. Back in 1970, (you could call this the Palaeolithic period), this ratio effectively stood at £11. It is difficult to say how quickly and to what extent the ratio should be relaxed after stability returns, but it is quite clear that we should be in no hurry about the process and that barriers should be set in place against it returning to £6 (and it should be recognised that these barriers will eventually fail).

Ratings agencies and depositor awareness

9. The reliance placed on rating agencies in the modern financial system is out of all relation to their reliability. Ratings agencies owe their duty to investors, but they are paid by issuers. This situation cannot be overturned, but it can be moderated. Rating agencies should be required to make meaningful deposits of cash with regulators against every published. These deposits would then be forfeited whenever a rating was moved downward by three or more notches within 30 days. This would oblige agencies always to take a pessimistic view, and make it impossible for them to award a high rating to any borrower whose credit was not genuinely undoubted.

10. The Bank for International Settlements should develop a Bank Reliability Index reflecting equally four aspects of banks: a) capital strength b) clear diversity of ownership c) range of business activity and d) the length of time since they were last significantly recapitalised. Age old plain vanilla banks with no dominant shareholders and high ratios of retail deposits would score highly on all elements. Investment banks would never score more than 75% because they would receive a zero score for "range of business activity". All deposit taking banks and brands should then be required never to publish a deposit interest rate without disclosing alongside it and with equal prominence their Reliability Index.

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Read more of Alistair's columns at his IC home page.

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Alistair Blair is a past winner of the Business Writer of the Year Award, and has worked in investment banking and fund management.

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