utorak, 21.10.2008.

Willem Buiter

Für Lo

Time to plan a swift return of the People’s Banks to private ownership and control

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The People’s Bank of Scotland (formerly known as the Royal Bank of Scotland) will soon be 57 percent owned by the British state. A 40 percent ownership stake in Lloyds-TSB-HBOS following their merger is also anticipated. The British state already owned Northern Rock and Bradford & Bingley. The Dutch state owns the Dutch rump of ABN-AMRO and Fortis Nederland. The US government owns 79.9 percent of AIG. Nine major financial US institutions have agreed to participate in both the US Treasury’s ‘voluntary’ capital purchase program and the FDIC’s guarantee program of senior bank debt and assorted deposit liabilities. ‘Voluntary’ is clearly used here in the sense it is used in the armed forces: “I need three volunteers: you, you and you there!” The fact that the US government did not name the nine banks that ‘volunteered’ is crazy - a clear violation of the rule that unless there are very good reasons for the state keeping something secret, and unless it actually will be able to do so, it should put all information in the public domain - and sad.

These partial, majority or complete nationalisations were necessary to stop the complete collapse of the financial sectors in the countries concerned. The reason for this threatened collapse was the utter failure of the old system of soft-touch regulation, self-regulation, toothless supervision and private ownership. There can be no return to the status quo ante.

But the state ownership and control phase should be as short as possible. The state is a dreadful owner and manager of banks and other financial institutions. It can just about manage a central bank - a much simpler job than managing a commercial bank, and one where there is a natural monopoly that makes comparisons of performance difficult. Even so, the job is often not done particularly well .

Anything else the state touches that involves the production, distribution and sale of private (non-rival and non-excludable) goods, becomes dreck very soon. Anyone for Sberbank, Vneshekonombank, Vneshtorgbank, the old French Crédit Lyonnais and the current German Landesbank as models for European and North American banking in the 21st century? I did not think so.

As majority or significant minority shareholder, the state has its rights, obviously. That includes its right to extract the inevitable populist pound of flesh from the banks now under its control. I hope it will be able to restrain the more extreme manifestations of ‘people’s banking’.

It makes sense that no dividends are paid to ordinary shareholders as long as the state owns preference shares in a bank. Limits on remuneration of board members and top executives are also appropriate. A clear-headed re-think of the incentive effects of different remuneration structures for banks and other highly leveraged institutions (HLIs) is clearly overdue. But an incomes policy for a few people in just one sector would be an abomination.
Excessive and inappropriate remuneration are first and foremost a problem of corporate governance, as even before any systemic damage is inflicted, the shareholders are robbed. I made some sestions for shareholders having line-item votes on the remuneration of the top-10 executives and the 10 highest-remunerated staff in an earlier posting on this blog.

The joys of state ownership and state control of banks

What can we look forward to until the government gets out of the banking business again?

(1) Political lending at the macro level.

This is already happening. The British government has told the banks it is giving capital to, that it expects them to maintain their aggregate lending volumes. This is bad cyclical stabilisation policy and bad structural policy.
Why is is bad countercyclical policy? The economy is about to go into recession. The creditworthiness of borrowers - households, SMEs and everyone except bankruptcy lawyers - is taking a dive. Banks should not be used to conduct countercyclical policy for the government. That’s what fiscal and monetary policy are for, and perhaps regulatory policy, including countercyclical changes in capital ratios or leverage ratios. Undermining the creditworthiness of new bank lending though forced lending, and deliberately courting a further weakening of the banks’ balance sheets is not the way to escape from the age of excess.

Why is it bad structural policy? The financial sector, and the banking sector within it, have expanded well beyond their socially optimal size. The financial sector has to shrink its employment, its range of instruments and services and the size of its balance sheet. It will undoubtedly have to shrink its exposure to the household sector. British consumers have built up excessive debt, both secured through mortgages and unsecured. The counterpart of household deleveraging will have to be a reduction in bank lending to the household sector. Painful, but necessary.

(2) Political micromanagment of bank lending

This will come. Indeed, some of it has appeared already, in the form of exortations for maintaining lending to households and SMEs. Harder forms of government-directed, that is politically motivated, lending will not be far behind. Three state-appointed board members for RBS and 57% share ownership mean that the government can and will ride its lending hobby horses. I have never yet encoutered a government able to resist the urge to do ‘good works’: lending for social housing; lending to the North East; lending to minority-owned businesses and to SMEs in general; lending to the not-for-profit sector. If these are deemed worthy causes, they ought to be promoted using fiscal resources, and through programmes and grants that are on-budget and on-balance sheet for the Treasury and properly audited by the appropriate political mechanisms and by such bodies as the UK’s NAO or the U.S. GAO. The quasi-fiscal shenanigans of politically directed lending imply a lack of accountability and are likely to result in inefficiency and waste.

(3) Jobs for the boys and girls

The Brits love quangos. I am sure every other country has its own version of the quasi-autonomous government organisations that provide asylums for the great and the good, their friends, relatives and dependents. Now there could be quite a few more of these grace-and-favour appointments for the government to squander on its supporters. And some of these positions might even pay reasonably well (even allowing for the constraints on bonuses that will no doubt be imposed). Non-executive board positions in one of the new People’s banks would be just right for recently retired members of cabinet, senior civil servants that have become surplus to requirements, trades union officials, representatives of consumer groups and other assorted politically correct dignitaries.

Only two criteria ought to matter for non-executive appointments to bank boards: expertise in banking matters and independence. Instead the following criteria will be key: (1) closeness to the government; (2) Safe hands/low likelihood of rocking the boat; (3) representativeness ( short/tall; male/female; Christian/Jew/Muslim/Buddhist/Hindu/Atheist; manufacturing/services; consumer interest/producer interest; short/tall; skinny/fat; beautiful/ugly).

Before the government are out of the bank ownership and control game again, we may all be looking back nostalgically to the age of excess.

(4) Distorted competition in product markets

Government-owned banks are likely to be able to to offer better terms to borrowers and other customers, because the main shareholder has deep pockets and does not aim to maximise profits. The government have not even been able to prevent Northern Rock from gaining an unfair competitive advantage. With behemoths like RBS and Lloyds-TSB-HBOS the likely distortions of the competitive level playing field will be much more serious.

(5) Distorted competition in funding markets

Other things being equal, where would you put your deposits, to which bank would you prefer to lend and which bank’s debt would you rather hold: a bank that is majority state-owned or a bank that is 100 percent privately owned. Me too.

So I expect that the state-owned/controlled banks may gain a competitive advantage over their purely private counterparts on the funding side of the balance sheet - and advantage that they can exploit to gain market share. An extreme version of this would have the markets lose confidence in all banks without significant state ownership, forcing the remaining privately-owned banks to enter the public stable as well.

Better regulation as a condition for future government disengagement from the banking sector
If, following a successfull stilling of the storm, the state were simply to pick up its marbles (with interest) and go away again, it is clear that the same conditions that created the recent blow-out would recur within a decade or so, unless there were a radical restructuring, at the global level, of the regulation of border-crossing financial intermediation.

Future regulation of banks and other HLIs will have to be quite different from what we have had in the past. The truth of the dictum that in the financial sector self-regulation means no regulation has been amply demonstrated. Future regulation will have to satisfy, among others, the following criteria.

(1) The domain of regulation has to be the same as the domain of the market. That means international cooperation and preferably regulation at the global level for systemically important financial institutions with significant cross-border activities.

(2) Regulation should apply equally to all HLIs deemed to be of systemic significance. That is, it should apply uniformly regardless of whether we call these institutions banks, hedge funds, SIVs, insurance companies or bicycle shops, and regarless of their ownership and legal status (e.g. private equity funds)

(3) Regulation should only relate to variables and criteria that can be independently verified by third parties. This means that Basel-type risk-weighted capital ratios as currently construed should be out, as the risk weightings depend on the internal models of the banks. These internal models are private information of the banks and the banks cannot be trusted to use them objectively, impartially and in the spirit of the regulations. That probably means going back to simple leverage ratios (debt-to-equity) as constraints on HLI balance sheets.

(4) Regulation should not depend on information provided by private, profit-seeking and possibly conflicted rating agencies.

(5) Regulation should try to set limits on leverage and mismatch (maturity, liquidity, currency etc.). Since the only reason to take on additional leverage appears to be the desire for greater risk (i.e. mismatch), setting limits on leverage could well be the only relevant metric for future regulation.

(6) Regulation should focus on funding liquidity and market liquidity as much as on solvency/capital. I recognise this is fighting yesterday’s war, but we might as well.
Given better corporate governance (not just for HLIs!) and better regulation, the government can get out of the ownership and control role in the financial sector. If it mistrusts the effectiveness of future governance and regulation, it could keep a minority stake in systemically important highly leveraged institutions - say the minimum required to give it one seat on the board (for an elaboration of this, look here). There are drawbacks to this, as I shall argue below, but the failure of private financial intermediation as a process and of many key private highly leveraged institutions has been so comprehensive and devastating, that it may well be wise to be safe rather than sorry, at least for the next century or so. In the long run, the government could withdraw from a governance role completely.

(7) We must find a way of putting senior creditors of banks and other HLIs at risk, without this threatening a collapse of the whole system. I don’t know whether it was the failure of Lehman that pushed the markets and banks over the edge, but it is true that, except for Lehman and Washington Mutual, senior unsecured debt holders of systemically important banks have not suffered losses in this crisis. It is possible that there was a view in the markets and among the vocal segments of the financial community, that there was an implicit guarantee of the senior debt - a one-way social contract with no pain or any other obligations for the debt holders. If that was the case, and if the breach of that implicit contract triggered the final act in the unraveling of the financial system of the North Atlantic region, then it is essential to rewrite that implicit social contract, through legislation, regulation and political commitments, to ensure that in the future all debt holders of the banks will always view themselves and their money at risk, even if their institutions are not at risk.

Treasury Secretary Paulson’s signing of the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily guarantee the senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts, may have been necessary, although I doubt it. Even if necessary, it still is a disaster from the point of view of moral hazard and incentives for future reckless lending and borrowing. Unless we can convince would-be future holders of senior unsecured bank debt that there is true credit risk attached to these securities, the banks won’t have any trouble funding their next son-of-subprime-mortgage lending bonanza.

Without putting the senior unsecured creditors at risk, there will be a continued temptation to overleverage the financial sector. It is key that all systemically significant HLIs be subject to a special resolution regime (SRR) that contains wide-ranging powers of prompt corrective action (PCA) powers for the Administrator/Conservator. The Conservator should, without having to put an HLI into insolvency, be able to order a partial debt-to-equity conversion for any and all unsecured debt, including senior debt. This should be possible without complete prior extinction of all the old equity. Before public capital goes into a bank, there also should be some mandatory debt-to-equity conversion, or some charge or haircut on the existing debt holders and other unsecured creditors of the bank.

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