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Debating the Vickers report on banking

by Robert Teitelman | Published April 11, 2011 at 12:01 PM

For months now, there has been considerable speculation that the U.K. would propose a sweeping structural reform of the banking industry. Much of this was believed to be coming in the form of an interim report by a group led by Sir John Vickers, the former chief economist of the Bank of England. Indeed, the talk led to pre-emptive grumbling from the heads of some of the big U.K. universal banks about moving assets overseas if worse came to worst. Well, that probably won't be necessary. Vickers released his interim report over the weekend and described it as "moderate," emphasizing increased capital, a U.K. version of resolution authority and the attempt to ring fence consumer operations. Indeed, it looked a lot like Dodd-Frank in the U.S., which means that big issues like too-big-to-fail and moral hazard remain, depending on how you feel about the effectiveness of the resolution authority or, more importantly, the will of politicians to enforce it in a crisis. And so it's more of the same, leaving the critics once again unsatisfied. In particular, any kind of Glass-Steagall-like separation of investment from commercial bank operations does not appear. Vickers himself was unrepentant: "We absolutely reject the notion that we bottled it," he said. "In no sense at all are these half-measures. These are absolutely far-reaching reforms."

Not if you ask Simon Johnson and Pete Boone, who weighed in caustically Monday in the Financial Times. They have been arguing for more radical steps for several years now, from shrinking the banks dramatically to separating functions to hiving off proprietary trading operations. And they have been repeatedly disappointed. Despite the arguments of some current and former central bankers like Paul Volcker and Mervyn King, policymakers and their political masters have opted to retain large, leveraged banking behemoths and to depend on reorganized and suddenly alert regulators and higher capital levies to do the trick. Johnson and Boone are left making the same old argument of imminent doom with greater and greater certainty.

"The banking system, on both sides of the Atlantic, is more dangerous now than before the financial crisis began in 2008," they write. "Before 2008 'too big to fail' guarantees were a possibility, now they're a certainty." Indeed, they offer a lot more of this prophetic certainty. "There is no cross-border resolution authority of any kind and none planned. For megabanks in trouble, the choice remains: Lehman-type collapse or Tarp-type bailout." All is woe woe woe. "The market is now pressing banks to take on more risks. ... Regulators are no better able today to see this than they were in the pre-Lehman era ... without serious reform, it will soon be a case of here we go again."

The problem here is that prophecy is not policy. Much of what Boone and Johnson say has real merit. Resolution authority is untested, and there are loopholes. Many of the practices that created the problems in 2008 remain. It is unclear if moderately higher capital levels will reduce risk. And the big banks have a lot of political clout. But the pair almost never go beyond an argument that's not for popular consumption and seriously explore the downside of a radical reshaping of banking: How much would it cost? How much pain would ordinary folks have to absorb? What would be the effect on economic growth? Are there good reasons for a large state like the U.S. or Britain to have large, global banks? Instead, and too often, the argument that doom lies straight ahead if we don't shrink the big banks relies on testimonials, from Volcker or King, or a few academic papers on subjects like the TBTF subsidy. Everyone cites each other, creating a hollow sense of affirmation.

Of course, the other side is no better. They rarely make the argument that much of what they've done is leaving us safer either. They speak not of prophecy, but of authority. Regulators are awake. More capital will make the big banks safer. Resolution authority will function effectively, reducing the problem of TBTF. Developed countries need big banks to service large corporations and fuel complex economies. Radically (even cosmetically) reshape the banks, and liquidity will diminish and the economy will fail. Banks are instruments of state power, and a superpower requires large, global banks.

Some of this is covered by a second column in the FT, arguing in support of the Vickers report (scroll down). The author is Martin Jacomb, the former chairman of the U.K.'s Prudential, and his perspective is broadly in line with the report. Jacomb, however, does make a number of points that are worth pondering. First, he says what's obvious: Banking involves risk. If you ask banks to provide too much of a capital cushion, they will have to raise their prices and lose business to nonbank sources of finance. This, in fact, is exactly what happened in the '80s and '90s, leading to bank deregulation. Second, regulation invariably creates the conditions that undermine it. "However, relying on a regulatory system means inevitably that managements will conduct their business up to the limits of regulation (given that competitors will be doing this) rather than relying on their own judgment as to where the prudential limits are. This is always the trouble with regulation. The paradox is that regulation to limit risk increases it."

There is a lot of good sense in that aphorism. I would add a corollary: The more rules that apply to a complex institution like a bank, the fewer any single rule matters. And a third: More rules create more rules, just as regulation tends to set up the need for deeper, more complete regulation. Jacomb says so himself: Capital levels will drive business to nonfinancial, nonregulated entities. And this is a problem with both sides of this debate. We have abundant historical evidence that leaving banks alone will create huge problems. But chopping them up in pieces will create the need for more rigid, more inclusive, more luxuriantly spreading rules. The end of this road usually leads to a kind of nationalization of banking, which suffers any number of its own problems and is (today) politically impossible.

Somewhere in there a middle ground hopefully beckons (and, if it doesn't, then a breakup scenario will eventually loom). But right now it remains difficult to find. Jacomb seems to be reaching for a form of regulation by principle, buttressed by shrewd incentives. I'm increasingly skeptical of our ability to construct dream machines of incentives for managers of large, complex and public companies. And regulation by principle has always been a tough endeavor in democracies driven by populist waves of fear and anxiety about large institutions. So for all the certainty, we still seem to be searching for the answer. - Robert Teitelman

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