Institute for Research in Economic and Fiscal issues

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Fiscal competition
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Fiscal competition and economic freedom

The Case for Systemic Banking Reform
by Gordon Kerr

WP 2014-01. Executive Summary

Bailouts have created a problem of moral hazard. This has exacerbated, rather than relaxed, the decline in integrity in banking that is the subject of this paper. Evidence of this decline is increasingly apparent. Year end 2012 provisioned and suffered fines and conduct settlements for just ten banks, nine of them US or UK based, totalled $235 billion, equivalent to a third of the 2008 US TARP bailout programme. This figure will increase. Analysts, regulators and policymakers have united in calling for culture changes and tightening of regulation.

Focussing mainly on the so called “free market” literature analysing the causes of systemic banking collapse, the paper first presents the conventional analysis, according to which the primary driver was government policy, particularly in the US with measures encouraging uncreditworthy borrowers to buy homes. Although these authors’ specific remedies vary, most are agreed that the bailouts were a good idea, and do not strongly disagree with the “once in a lifetime event” narrative.

Whilst accepting that these policies contributed to problems in banking, the paper argues that if the metrics by which solvency of banks are measured had been more realistic, then problems in banks would have been diagnosed much earlier. Separating the analysis of harmful banking from harmful policy (mortgage loans for all) is essential.

The paper mentions the twin main reasons for the exponential growth in credit derivative products. Firstly the accounting rules enable a bank that switches a loan portfolio into credit derivative format to book the bulk of lifetime hoped for loan profits at the start of the transaction, and secondly the regulatory capital consumed under the Basel rules is substantially reduced.

Whilst some of the rule changes since the crisis broke have been modest improvements in the assessment of bank solvency, none of them have addressed the major concerns of fundamental system threatening weakness of Value at Risk (VaR), and accounting, particularly for credit derivatives.

Present preferred regulatory response is to tweak global rules. But there are major problems:
a) global rules import any flaws to all jurisdictions;
b) continuing failure of regulators to understand problems with the accounting for instruments such as credit derivatives.

These solutions, more than five years after bailouts, have not addressed the moral hazard that is the proximate underlying problem. The decline in integrity is at or close to its nadir. In the UK banks have been shown to have colluded to dishonestly misappropriate customer funds via fake insurance products. A simple solution to these problems is to bail in bank directors and senior management. A proposal is set out.

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WP 2014-01

PDF - 739.7 kb

The Case for Systemic Banking Reform

by • Gordon Kerr

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