At the crisis point of the credit crunch last autumn, policymakers faced three challenges. First, they needed to stop the panic. Secondly, they needed to recreate the conditions for economic growth. Finally, they had to take steps to ensure the disaster was not repeated.
The first of these tasks was eventually achieved, though it proved more difficult and costly than many had imagined. Policymakers were criticised both for being slow to respond to the scale of the problem and for giving too little attention to international co-ordination. But you cannot point both these fingers at once, so to speak, since the search for international co-ordination slows response times. On the whole, governments and central banks performed their daunting job pretty well. The proof of that is that the banking system, although challenged in its long-term funding and risk averse in its lending, is still functioning today. It was not certain last October that one would be able to write those words in mid-2009.
Overcoming the first challenge is a good start on the second challenge—getting the world economy going again—since the restoration of confidence is indispensable for growth. The paradox, though, is that the more rapidly confidence is restored the harder it is to address the third and, in the long run, most vital question: how do we stop it happening again?
The panic is now clearly behind us, and the worst of the inventory shake-out in manufactured goods has also taken place—two fundamental conditions for a cyclical recovery. We are also benefiting from a monetary stimulus of biblical proportions. This must and in due course will be withdrawn. The universal response of governments to the emergence of budget deficits on a scale that could never have been imagined has been procrastination. And overall, things will feel worse, probably much worse for much longer, before they feel better. This should concentrate minds on the "how do we stop it happening again?" question. Political will to tackle this is likely, after all, to fluctuate according to how bad "it" is felt to be.
Three obstacles stand in the way of making sensible progress. One is misdiagnosis: if we don't understand what went wrong we are unlikely to fix it intelligently. Another is the preference of the political process for small steps over substantive ones. But in banking we are still playing with fire and should not allow ease of implementation to set priorities. The third potential problem is the widely-shared desire to find a global solution for the banking system. This ought to be an eventual objective. It is not the objective to start with, though, not only because it is far harder to achieve than people tend to think and there are real conflicts of national interest to contend with, but also because any answer that can be agreed on quickly is unlikely to be the right one. Meanwhile the world will benefit from a little competition—constrained, of course, by the mobility of capital—between regulatory systems. We've had plenty of error; it's time for some trials.
***
The bubble burst in the sub-prime mortgage area because that was the weakest part of the bubble wall, not because it was the cause of the bubble. To find that we need to go back to the growing imbalances in world trade brought about by the introduction of a huge country—China—into the market economy, a country playing by subtly different rules from everybody else. This does not mean the Chinese were responsible for the crisis. It means the world has mismanaged the return of China to capitalism. The process that followed has brought about an immense surplus in China, an immense deficit in the importing countries, principally the US, and, as a corollary of this payments deficit, a huge buildup of debt. This has been accompanied by low inflation rates and low rates of interest, the product of unnaturally cheap Chinese labour and unnaturally large Chinese investment funds.
It is unfortunate, writing with hindsight, that this low inflation occurred at the time when western central banks decided their main job was to target inflation. Finding that inflation declined, they naturally took the credit. (Central bankers are human too.) They concluded that their beautifully judged 0.25 per cent interest rate moves—financial keyhole surgery—had kept the demon at bay, just like the American Indian tribe which believed that climbing the hill before dawn made the sun rise. No wonder they underplayed the asset bubble; I should have done the same.
Low inflation and interest rates—and a generally benign economic environment—fooled the banking system and its customers into underestimating risk. Fixing this means addressing both the international imbalances and the weaknesses in the risk management practices of the banks, which have led to a dozen "once-in-a-century" events in two decades.
The international imbalance issues are enormous. They are probably better understood than they were a year ago, but not by much. "Surplus" countries such as China and Germany still consider themselves virtuous, unfortunately. But if there is no progress here, the banking problems will recur, whatever reforms are made. Asymmetrical currency systems—half the world floating and half the world controlled by governments—and asymmetrical market systems (ditto)—cannot easily coexist in an open world trading system. Tensions will spontaneously arise, and the means of resolution is not clear. Since these unresolved issues pose a danger to the trading system on which prosperity rests, this matters.
*** Let me turn to the weaknesses in the banking system. We have obviously got a lot of things wrong. The regulators proceeded as though medium-sized banks could safely be allowed to fail until one actually did, at which point they realised that the failure of one bank would produce a run on all. Central banks had strict rules determining what sorts of securities—only the finest—they would buy from banks to provide liquidity. When the crisis struck, they discovered that the banks no longer held significant quantities of these assets, so they were forced to buy lower quality assets (such as mortgage backed securities) because this was all the banks had to sell. Banks had too much risk on their books and too little liquidity. Everyone—I simplify, but almost everyone—had conspired to produce this ridiculous situation.
Think of the banks as drivers in cars on the motorway. They are all driving too fast, far too fast, but they are only aware of relative speed—who's overtaking whom?—rather than the excessive speed of the whole convoy. The boy-racer syndrome is evident. Suddenly there is an accident. Some people have better brakes than others, but even with good brakes you can find people running into you from behind.
Managing a bank is a strange business. For every asset you add to your balance sheet—every element of growth, if you like—you take on a little parcel of risk. You must work out whether this risk sits well with the risks you already have before deciding whether to pursue the growth that appears to come with it. Chairing the treasury committee, which determines the shape of a bank's balance sheet—its overall risk appetite and the degree of the (inevitable) maturity mismatch of assets and liabilities—is, for me, the most important role of a bank chief executive. In the last decade, alas, this function has come to be seen as "technical," or subject to computer modelling. Human judgement has not been applied, sometimes not even to the decision not to apply human judgement.
Bank board members, usually experienced leaders from other business sectors, are ill-equipped to understand the risk-growth tradeoff. In their world, the pursuit of organic growth is often risk-neutral. They quite literally do not know what they are doing, as much empirical evidence suggests.
There are many efforts underway to ensure that the same mistakes are not repeated. Most of the suggestions for reform made earlier this year by Adair Turner, chairman of the FSA, have been incorporated into a white paper published in early July by the chancellor Alistair Darling. They are designed to strengthen the existing system, rather than replace it. But we must not forget that regulators know no better, and usually a good deal worse, than the regulated. The melancholy truism will not change on the back of a couple of tough years. The failure of regulators to play any useful role in preventing the crisis can be no surprise to anyone who has observed their methods of work. We would not expect traffic wardens to bust drug dealing syndicates.
Yet regulators are not just the enforcement branch, they are the rulemakers too. The aim of new rules is clear: if a bank's risk-taking activities present a threat to its solvency, and if the taxpayer is obliged to underwrite that solvency, the risk-taking activities must be controlled and curtailed—but not to the extent that banks cease to provide risk capital for economic growth. Three approaches—by no means mutually exclusive—are being floated: make banks smaller so that future rescues will be cheaper; force banks that raise deposits from the public and so qualify for taxpayer support to restrict their trading activities drastically; impose onerous capital requirements to restrict the scale of a bank's trading and provide a bigger cushion against failure. It is here that we shall be best served by regulatory experimentation, which is why the thrust of the Turner/Darling reforms should be welcomed. It is more important to do something effective, soon, than to fail to act during a protracted search for the perfect outcome.
As the financial industry's pained response to Turner/Darling shows, however, the banks will noisily protest that this is the wrong time to introduce new regulations. They will argue that chastened bankers are hardly going to repeat recent follies, and that bringing in new rules now risks making finance scarce. They will also tell their national governments that early moves by one government will threaten that country's competitive standing in finance, a particular neuralgia for the British authorities. One should pay a little attention to these arguments, but not much. It is important to start moving, openly and perhaps untidily, towards a new framework.
We have, after all, been reminded in a forcible and terrifying way of why banks need capital. It used to be there to reassure depositors that banks were good for their customers' money; the depositors were then joined by a special class of depositor—other banks—who were supposed to know how to judge their peers accurately. (Indeed, when banks would not lend to each other at the height of the crisis this told us all we needed to know.) Then governments, learning how expensive bank crises could be, also began to take an interest in capital levels. But in the decadent phase of the late 20th century, the driver changed. The new issue became the banks' desire to hold no more capital—and no more liquidity—than their international rivals. We went along with that, and came to regret it last autumn when we returned to the banking ecology of the early 18th century.
Finally, a word about the role played by accountancy in the crisis. Everyone can now agree that it was wrong to allow underlying capital ratios to decline as the boom proceeded, but this problem has occurred before, and it is more easily described than rectified. Mark-to-market accounting, which obliges banks to value assets at the price they would fetch on immediate sale, has been blamed for amplifying the severity of the downturn. And it did. But in a period of sheer panic books that were not marked to market were presumed to overstate asset values and universally seen as suspect. So the market marked your book to its version of the market, even if you didn't mark it there yourself.
Bankers know, believe it or not, that there is a banking cycle. That in something like two out of every seven years, on long historical averages, credit losses strike. They used to handle this by putting reserves away in the good years. Smoothing profits now ranks, along with paedophilia and parking in bus lanes, among the most dreadful imaginable crimes. Instead of being illegal, building up the counter-cyclical credit reserves of lending banks should be made compulsory by the accountancy authorities.
Another reform is essential too. When a bank sells a derivative instrument to a customer, it stands to receive modest fees annually over the life of the instrument. The accountants insist, with the traders joyfully concurring, that the lifetime stream of income should be rolled up into a present value and taken as a profit in the first year—more precisely, half of it is taken as a profit, the other half being paid out in cash to the boys and girls in the trading rooms. (The transaction does not generate enough cash to pay them with, so the bank has to borrow it.) No one should be surprised that the outstanding principal of derivative instruments is astronomically large; the strongest possible incentive exists for creating more and more of them. If the accountants insisted that the profits were spread out over the life of the instrument the world would be a far safer place.
Then there is the wicked doctrine that insists that if a bank suffers a credit downgrade which causes its counterparties to mark a loss on their exposure to it, the weakening bank itself marks an equal and opposite profit. (You can find this in the 2008 results of all our tin-pot banks; it usually adds up to billions of pounds; it is called "Gains on Own Debt"; it represents no gain in any possible meaning of that word.) The accountancy theorists believe that money, like energy, is neither created nor destroyed; if X has a loss, then Y must have a profit. Alas, no. As we have learned in the last year or two, money can be destroyed. Lots of it.
WH Auden, frustrated at his inability to prevent the Spanish civil war, famously lamented that "Poetry makes nothing happen." If only the same could be said for accountancy.
