As a follow up to his article in the last edition of Treasury Today Asia, our treasury insider looks at four potential ways to strengthen the current fragile banking system, and considers their likely effectiveness.

The current regulatory approach is one in which I have little faith as a means to mend or even really change the financial system. So, what are the alternatives? Well, whilst there are doubtless other possible solutions, there are four interesting alternative views (spurred on by last issue’s article) that I’d like to explore here. Namely: Fintech will save the day; separate credit from money; revive Glass-Steagall and rolling sub debt.

Does Fintech hold the answer?

Clearly technology is having massive impacts on finance. From algorithmic and high speed trading to electronic and mobile payments; social investment, peer-to-peer lending and trading; private currencies; and more. Many of these technologies are impressive and appear to have the potential to disrupt banks and drive radical change. Peer-to-peer lending, for instance, shows great promise, as reflected in soaring IPOs of some firms. By cutting out the middle men (traditionally banks), they promise lower fees. By harnessing big data, they promise better credit assessment.

Three big questions remain: firstly, how will they survive the next downturn? Lenders are likely to lose their appetite when defaults mount. Secondly, how will they scale? Will these lenders be able to step in to replace conventional credit markets? And if so will they provide healthy liquidity? Finally, when they hit credit losses at scale, will they need to be bailed out like banks? If that happens, then we have just created new high tech banks with the same fragility that we face now.

These platforms currently appear to meet the criteria that both risks and rewards are private. Banks under the current moral hazard regime have private profits and social (eg tax payer) losses. If the new platforms become too big to fail, then we have not achieved sustainable finance. Similar problems face peer-to-peer trading – both retail and institutional. Traditional markets provided liquidity; this is already drying up under current regulations. Fintech platforms struggle even more without market makers. In many cases, Fintech is not really disrupting finance but simply building new channels to traditional markets. And it may not have the advantages that it boasts.

Separate credit from money?

Here, it’s important to explore the distinction between banks and banking. We have seen low tech shadow banking can quickly reach levels requiring government bailout. It is likely that Fintech will not just reach – but actively target – too big to fail. What business would forego privatised profits and socialised losses? One would be a fool to refuse a free lunch! The question though is not Fintech vs banks. The question is what to do about banking (whether performed by Wall Street, Silicon Valley, or any other player) which conflates money and credit to disastrous effect – driving leverage and moral hazard? New regulations will just push the banks themselves and their various non-bank competitors to find creative ways to build leverage again, to game the system, to force the next crisis and the next round of bailouts. What some industry commentators suggest is to separate money from credit. Money would remain government issued and controlled as a medium of exchange. Credit would be restricted by revising accounting rules.

As the authors of the book ‘The end of banking – money, credit and the digital revolution’ say: “The total value of financial assets of a company has to be less than or equal to the value of its equity. They explain that this reading highlights that companies have to back assets that are someone else’s liability with their own funds, that is, equity. Companies cannot finance credit with someone else’s credit.”

This would indeed solve the problem. It would also create wrenching change and radically reduce credit availability. Since we seem to be hooked on credit driven growth as a replacement for productivity driven growth, this could make the solution politically and socially unworkable.

Clearly technology is having massive impacts on finance. From algorithmic and high speed trading to electronic and mobile payments; social investment, peer-to-peer lending and trading; private currencies; and more. Many of these technologies are impressive and appear to have the potential to disrupt banks and drive radical change.

Revive Glass-Steagall?

Separating investment banking from commercial banking has been much discussed. Partial steps in this direction have been legislated – for instance the Volker rule in the US and ring-fencing in UK. The idea is to create ‘safe banks’ which would have deposit insurance and separate them from investment banks which would do the dangerous stuff without government support. The difficulty is in keeping safe banks safe. Safe banks used to pour deposits funds into housing. But the term ‘safe as houses’ seems laughable after the last crisis, which was largely one of housing leverage.

With all the technology available to banks now, keeping the separation intact will be difficult. So, as described above, the issue is probably more with banking than with specific banks. Separating money from credit (for all businesses whether they call themselves banks or not) is probably more robust than trying to segregate different types of banks. In any case, full reinstatement of Glass-Steagall would be a wrenching change for the economy and might be politically unworkable.

Rolling sub debt?

As described in my previous article, central bankers and others have proposed that banks be forced to issue substantial amounts of ten year rolling subordinated debt as a solution to financial fragility. The need to sell a material chunk of sub debt every year would focus management’s minds on their risk profile, and continuous market pricing of sub debt would provide a market view of the institution’s riskiness.

Of course, buyers of such rolling sub debt would want to understand the issuer’s business and risks. This would likely drive simplification, which is likely to take the form of downsizing (since size increases complexity) and specialisation (since universal banking is harder to understand). This might also provide economics for independent risk assessment, rather than the crazy conflict of interest built into today’s rating process.

Investors will demand reliable reporting from sub debt issuers, so this might provide impetus to clean up the current accounting standards mess which seems only to enrich advisors and confuse everyone else. Since transparency will equate with lower pricing, issuers have a strong incentive to be clear about their businesses.

As discussed previously, simple economics imply that banks will outspend and therefore out manoeuvre regulators. The beauty of the rolling sub debt concept is that it unleashes the markets to regulate the banks. Sub debt investors will be able to pay to keep on top of bank obfuscation, and thus to keep the banks honest. Dodgy banks will have a very high cost of capital. Markets are out of favour these days, but they are the most efficient method of capital allocation unless incentives are distortive. Pre-crisis politicians wanted more home ownership – markets delivered brilliantly.

The other advantage of rolling sub debt is that it allows the banks and the markets to figure by supply and demand how fast to adapt and in what direction. It is likely to be better to let banking evolve under market discipline rather than to ask regulators to decide what banking should look like. And since the markets will be left to determine how to reduce financial fragility (by deciding how to optimise risk and reward), the regulators will be freed to do a much simpler job – ensure honest reporting (and hopefully jail and bankrupt offenders).

Since it is not prescriptive on how, the rolling sub debt solution subsumes some of the others that I looked at above. We will find out from sub debt pricing whether investors prefer higher or lower tech banks, specialised investment banks separate from commercial banks, and so on. We may find some of the more inscrutable branches of finance go back to being partnerships, as was the norm in the past for investment private banking, because it is too hard to explain the business to investors. We might even end up in a situation from which the separation of credit from money becomes less jarring.

Conclusion

There are many potential ways to reduce financial fragility. Since banks have more resources than regulators, regulation is unlikely to succeed because the banks will just find new ways to game the system. For now, of the options discussed in this article, forcing banks to issue material rolling ten year subordinated debt still looks like the most workable current alternative. It is a clean yet strong mechanism that imposes strict discipline on risk in banking without regulating micro behaviour. It allows the markets to find optimal solutions to this worrying financial fragility.

The views and opinions expressed in this article are those of the authors.