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At a recent conference, the moderator closed a panel discussion on the future of transaction banking by asking for our thoughts on the future impact of the current regulatory tsunami. My answer: there is a structural asymmetry in bank regulation – bankers are paid more than regulators. Regulations essentially provide cover under which banks maximise their rents. When banks have finished the ‘cover your back’ part of compliance, they will start working on how to game the system, thereby sowing the seeds of the next banking crisis.

Is this just David having a rant against the banks, I hear you ask? Well, if so, I am in distinguished company. In fact, many of my closest friends are bankers and I have been working with bankers for 30 years. Bankers, like the rest of us, are subject to collective delusions, as the interesting research into many lost personal fortunes in the sub-prime debacle illustrates. Gillian Tett at the FT concluded: “it is groupthink and wishful thinking – not deliberate malevolence – that poses the biggest risk in finance.”

The root of our current fragile banking system lies in the conflicts of interest and distortive incentives that Western societies have created in the banks’ playing field. Our governments set the laws that define the rules of the game; bankers then go out and play their best. This is fair enough, if the rules align with societal needs. They do not.

In many ways, the global financial crisis was the result of banks responding enthusiastically to government incentives to increase home ownership. The policies that supported this supposed social good, and the institutions like Fanny Mae and Freddie Mac, were complemented by banks energetically slicing and dicing credit so that more risk could be absorbed. Of course, we have now seen that no amount of financial engineering can convert sub-prime into AAA – at least outside of the magical world of credit ratings.

A little history

It has not always been so. A multitude of metrics show that finance has grown enormously since the wave of deregulation in the 1980s. And the run of ever larger financial crises suggests that finance has grown out of control.

The FT’s Martin Wolf – interviewed by Boston Consulting Group (BCG) – made some interesting observations about the new normal: “The leverage we’re seeing now — 25 to one — is quite new. It’s not the way banks used to run in the UK and the US, which I know best, 60, 70, 80 years ago. They used to have leverage of, at most, ten to one, often even just five to one. So, moving to such extreme leverage as we see today, where the sound institutions have leverage of around 20 to one, is actually relatively new. Having such undercapitalised banks, in my view, is one of the reasons why they give us so little in terms of growth and development.”

Finance pay which ran around 100% of US average pay post war through the 1980s, has since blown out to 180% – nearly doubling – according to Simon Johnson in The Atlantic. Finance’s share of GDP quadrupled from 2% to 8% in the same period, according to the US Bureau of Economic Analysis. And it is the same story with finance’s share of stock market values and share of profits.

The root of our current fragile banking system lies in the conflicts of interest and distortive incentives that Western societies have created in the banks’ playing field. Our governments set the laws that define the rules of the game; bankers then go out and play their best.

No value added

Some bankers would probably argue, and perhaps even believe, that these global and function-spanning masters of the universe with their hair raising leverage are contributing to a more efficient world; and that their generous salaries pale in comparison with the social good they generate. The data suggests the opposite. Not only are banks skimming off more and more value, they are doing it to the detriment of the real economy.

Research by economist Thomas Philippon at New York University shows that the cost of financial intermediation has risen from 2% to 9% over the last century. For context, retail and wholesale trade have both shrunk by about 20% in this period, on the back of the same lower costs and rising efficiency that is available to the financial sector.

Even more worrying is the extensive evidence that banks are not adding value to society, but on the contrary, are taking value out – extracting higher and increasing the cost of financial intermediation. As Martin Wolf told BCG: “If you look at what the banks have been doing, they’ve predominantly been lending to leverage up property assets. Most of it has been collateralised by property, mortgages of various kinds. They have been doing very little lending to small and medium-sized enterprises, while the big corporates are all dependent on the bond market. So, actually, the link between bank lending and growth has become incredibly weak.”

Indeed, US Bureau of Economic Analysis data shows that the growth of bank profits is a mirror image of the decline of manufacturing profits – the banks have been eating the real economy’s lunch!

And that’s not all. Research by economist Thomas Philippon at New York University shows that the cost of financial intermediation has risen from 2% to 9% over the last century. For context, retail and wholesale trade have both shrunk by about 20% in this period, on the back of the same lower costs and rising efficiency that is available to the financial sector.

Philippon concludes that ‘financialisation’ has been a disservice to society: “According to this measure, the finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.”

Next steps

If you accept my two main points so far (that bankers will end up gaming the post-crisis banking regulatory system because they structurally have more firepower than regulators, and that globe-spanning universal banks are draining value from the real economy) then you will want to know what can be done to improve the situation.

The answer, in a nutshell, is “not much” – now that Wall Street’s regulatory capture of Washington (and the equivalent on the other side of the Atlantic) has essentially set the rules for the current cycle. The key rule is that moral hazard is preserved. This means that banks are empowered to exploit the privatisation of profits backed by the socialisation of losses in the “too big to fail” sector.

Adding fuel to the fire, the complexity and newness of the latest wave of regulation gives bankers a massive playground of obfuscation in which they can confuse customers and shareholders alike to maximise their rents. They will be smart enough not to repeat the error of the banker who said of Basel III: “The client doesn’t want to do simple calculations because treasuries are full of morons.”

My conclusion is that we will probably need another derailing to stop this train. And it might not be too long coming.

What’s the alternative?

Clearly something had to be done in response to the global financial crisis. Even if we accept that some of the problems, such as sub-prime and excess leverage in real estate, were politically driven, the crisis clearly showed the fragility of the banks. But rather than ever more complex regulation, and the inevitable collateral damage and unintended consequences of it, we might have tried structural reform.

Re-enforcing the separation of investment and commercial banking that was shattered by the repeal of Glass-Steagall in the 1980s was proposed by many eminent observers and experienced regulators. But, apart from limited take up of the Vickers report in Britain, the banks managed to quash the idea. In fact, the American solution to the systemic risk posed by Goldman-Sachs (previously a pure investment bank) was to inject a dose of heart-warming moral hazard by turning it into a bank holding company!

Adding fuel to the fire, the complexity and newness of the latest wave of regulation gives bankers a massive playground of obfuscation in which they can confuse customers and shareholders alike to maximise their rents.

Given the plethora of data I have referenced above, I doubt the bankers’ claims that universal banking brings scale economies that benefit the real economy. My personal experience has been that Fixed Income Clearing Corporation (FICC) and commercial bankers barely talk to each other within the same institution. That inclines me to believe that “too big to fail” is more like “too big to manage,” as concluded by the St Louis Fed and more recently by HSBC’s CEO.

Still, we have to assume – either because size brings benefits we have failed to discern or simply because of the depth of regulatory capture – that banks will not be broken up.

Market discipline

An intriguing idea surfaced in the immediate aftermath of the crisis. It was proposed mainly by central bankers, and I waited eagerly for the ensuing media discussion (it never happened). The common theme was to let the markets police the banks. Hedge funds and investment houses have the budget to hire bankers and physicists to keep up with the banks. So force banks to issue some fairly unpalatable funding, and the pricing of that will enforce market discipline on them.

William Poole (ex-President of the St Louis Fed) made a very clean suggestion in the FT in 2009: force banks, as a condition of their licence, to issue ten-year rolling subordinated debt amounting to 10% of their assets. The ten-year rolling part ensures continuity of assessment. The subordinated part ensures that investors will have serious skin in the bank game. And the 10% of assets keeps it material. Incidentally, Julie Dickson (Canada’s superintendent of financial institutions) also suggested sub debt and using market discipline to police the banks in the FT in 2010.

Corporate treasurers are often cited as a strong use case for global banks. But the truth is that no bank really spans the globe, so we have to multi-bank already. And megabanks are not as seamlessly integrated as their marketing departments would have us believe. As such, using a number of smaller banks is not so scary for corporates.

Although William Poole was structurally astute in his suggestion, he definitely got the regulatory psychology wrong when he concluded his letter with this optimism: “A return to the status quo ante, with banks enjoying the benefits of ‘too big to fail’, does not seem likely. Regulators will not dare risk a repeat performance. Bankers who think that their political influence will control the regulatory process are in for a rude surprise.”

I fear the bankers got the last laugh – at least for this cycle. Obviously, transparency is a prerequisite for market discipline. The markets cannot police the banks if the banks are not transparent. Bankers, whose primary profit centre is customer ignorance, detest transparency, and are endlessly creative about the benefits of opacity.

So, strict enforcement of accounting clarity (which I realise is not easy) will be needed. This will be coupled with pressure that will come from investors to disclose meaningful information about derivative and cash exposures, so that they can assess the risks. In the end, investors will not buy sub debt of a bank they cannot understand. So market discipline will likely succeed in shrinking and simplifying the banks where regulation has failed.

According to the St Louis Fed, “Most, if not all, of the megabanks would have failed without government support during the financial crisis. In other words, in a truly free market, most or all of those banks would have exited.”

What does this mean for treasurers?

Corporate treasurers are often cited as a strong use case for global banks. But the truth is that no bank really spans the globe, so we have to multi-bank already. And megabanks are not as seamlessly integrated as their marketing departments would have us believe. As such, using a number of smaller banks is not so scary for corporates. SWIFT and other providers can connect us to multiple banks.

Ripple provides an exciting model for even more seamless finance in the future. And we would benefit from banks collaborating more rather than aiming for world domination. So, for those treasurers with the bandwidth to look beyond the current regulatory tsunami and the possibility that it could trigger the next banking crisis, planning for a more heterogeneous banking ecosystem might be one for the to-do list.

The views and opinions expressed in this article are those of the author and do no necessarily coincide with the editorial views of the Publisher or Treasury Today Group.