But the wildest signs of the crunch are surely over. Those queues outside Northern Rock 18 months ago were a once in 140 years experience. Let's hope the next run is another 140 years away. Investment bank collapses are more common. But unless a lunatic gets into the top slot Goldman Sachs or Morgan Stanley, the next Lehman is surely two or three decades away: that’s how long it would take to grow any of their remaining rivals into a player of comparable substance.
Nevertheless, preventing or at least postponing the next giant financial calamity is a subject which is occupying many high class minds. 100 per cent insurance of bank deposits which paid out instantly would be a fine thing from the public’s point of view, but a disaster from a policy point of view. Somehow, you know in your bones that the widespread calls for such insurance in the wake of Northern Rock’s collapse were nonsense. But to understand it with your brain, I recommend “The Regulatory Response to the Financial Crisis” by Professor Charles Goodhart, a heavyweight commentator on financial policy whose 40 years of practical experience include lengthy stints at The Bank of England and The London School of Economics.
Despite starting his book with three pages of acronyms (“pca.”: prompt corrective action; “NADJ”: “not adjusted”) - to which the reader will refer frequently, Goodhart deals with the subject very accessibly, enlisting among others Mother Teresa, the Pope, harlots and eunuchs to illustrate various points. 100 per cent insurance of deposits won’t work because it is a crook’s charter. What is needed, argues Goodhart, is a mechanism by which troubled banks are automatically nationalised (Professor Goodhart doesn’t explicitly say, but I assume he envisages, that this would involve zero recompense to shareholders), their managements dismissed, and their deposits guaranteed. So there would be no messing around with white knights and arguing the toss with shareholders, who would instead recover only what was left two or three years later when the government had covered the cost of its guarantees and sold the bank back to the market. This regime would hold back adventurous managements… at least a bit.
But how do you deter banks from becoming troubled in the first place? Well, just as the Bank of England moves interest rates up and down, it should also move allowable “loan to value ratios” up and down. Thus it would have forbidden Northern Rock and others from lending 125 per cent of the value of a house. Banks’ capital ratios would likewise be set according to changing circumstances. Neither policy would be easy to enforce, because they would reduce profits and restrict credit supply to those who need it most (in other words to the sub-prime).
Even more importantly, financial resources would flow out of the regulated sector into an unregulated, or less regulated, financial sector. Secondary banks, structured investment vehicles, investment banks offering money market funds, credit card companies, retail loan providers… there is and will always be a deep well of marketing and financial ingenuity deployed just outside the area which any financial regulator addresses. The reason is simple: in normal times, regulation restricts profits. But capital seeks profits. Regulation therefore promotes unregulated activity and makes it more profitable than it would otherwise be. And it cannot prevent the regulated sector yearning to participate in the unregulated sector.
Professor Goodhart calls this The Boundary Problem and his description of it in one of the closing chapters of the book is a compelling analysis of this under-appreciated axiom of financial regulation.
This book is an excellent primer in the micro and macro issues which caused the credit crunch and some of the key ideas doing the rounds as policy-makers seek to ensure the next one is a long way away. Its 140 pages could be read in a sitting. I commend them to you.
