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.
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.