| More on the economic downturn |
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| Written by Dr Eamonn Butler | |
| Saturday, 27 September 2008 | |
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Worldwide central bank intervention might have calmed the financial sector a bit, but I still think that our present problems are due to too much government rather than too much markets. The rot started when the US authorities started forcing mortgage companies to make bad loans. The Community Reinvestment Act 1977 had the laudable aim of trying to make sure that people in poor areas had access to loans. Strengthened in 1995, it forced lenders to give mortgages, even in areas where they thought the property market was dire and the risks of default were high. Sub-prime mortgages, as we have learned to call them. The banks packaged those bad loans to reduce their risk, but that just spread the disease to others. Institutions started failing, and even 200 regulators on the case couldn't save Freddie Mac and Fannie Mae. Great work by the regulators, that. Meanwhile, Alan Greenspan at the Fed and Gordon Brown at H M Treasury were taking the credit for an economic boom. But it was a boom fuelled by easy money – low interest rates that induced people to borrow more and more, without thought to repayment – and Brown's reckless overspending. After 9/11 and the fears of what that might do to the world economy, even more credit was pumped in. But after ten years and more of this credit binge, some sort of hangover becomes inevitable. Sure, markets are only human. They can't be perfect. They work fine most of the time, but like motorway driving, you do get the occasional shunt when someone doesn't see what's coming. And indeed the occasional multiple shunt. That's a good reason for the government to make sure people are fit to drive – it is no reason for the government to take over the driving of every car. I can see the case for intervening to staunch a crisis of confidence, since markets are built on that very human necessity. But a hair of the dog never actually helps a hangover. Monetary authorities should stay focused on the threat of inflation, which is the biggest destabilizer of markets – obscuring real prices and so throwing future planning and investment out of kilter. Regulators should focus on the financial fitness of institutions, raising concerns at an early stage, and when inevitable failures do happen, facilitating their orderly wind-up. Frankly, the Bank of England would be better at that job than the bloated, distant Financial Services Authority. And when institutions do take too many risks and fail, what's left should go not to the shareholders, but to the customers whose trust has been breached. Comments (2)
But Government Licenses the Sets the Terms of Limited Liability of Bankers
written by Nigel Sedgwick, September 27, 2008
The banking regulator's bedroom fantasy written by Per Kurowski, September 27, 2008
Dr Eamonn Butler writes “The rot started when the US authorities started forcing mortgage companies to make bad loans.” and he is absolutely wrong.
The rot started when in the late 1980s the financial regulators had that bedroom fantasy that they could get rid of the risks of bank defaults; and started to direction the capital flows, inventing the minimum capital requirements for banks based on vaguely defined risks and empowering the credit rating agencies to show the way through the mined fields. Has the credit rating agencies no given AAA securities collateralized with bad loans there would have been no market for bad loans and when there is no market for bad loans there are no bad loans... Finance 01. Write comment
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In particular, the limited liability company (and its friends) are all creations of government. Without this, the owners (shareholders) of companies (including banks) would be personally liable for the debts incurred by their companies.
Quite rightly, we need limited liability in the large-scale economies that we now have. However, such grant by government needs to be balanced by specific protection by government, for the customers and suppliers of limited liability companies.
What we currently have is a failure in such protection, quite definitely by government, thought doubtless encouraged by the very bankers who benefit from its lack. This is in providing sufficient protection against the downside risks of the limited liability that government licences.
I see three immediate possible changes to the rules, under which limited liability licencing of banks is done, that would be of potential benefit in the future:
(i) A higher requirement on the amount of shareholders' funds that a bank requires for every dollar of deposit that it can take. This would protect against an even greater downturn/disaster than now, before those other than shareholders would be at risk.
(ii) Partial removal of the limited liability nature of banks, by requiring shareholders to provide a limited guarantee (say at 50% to 100% of the nominal value of the share capital they own), in addition to the actual share capital itself. [Compulsory share splits would be required should shareholders' funds rise above some modest multiple of the total nominal value of shares.] This limitation by guarantee would facilitate (i) above by making it easier for bank shareholders to obtain competitive rates of return compared to investments in non-banking companies, without freeing them of the ultimate level of risk. However, it would complicate the trading in shares.
(iii) More stringent limitations on the level of deposits to be held in fractional reserve, thus reducing the funds available for loan by each individual bank (and reducing the money supply without directly increasing interest rates), which should favour a more prudent loan policy. In fact dynamic changes to the fractional reserve requirement could be used by central banks to control money supply, as an alternative to or addition to the bank base rate (though variations would need to be modest and constrained in gradient). Such central bank action would allow more direct and quick reduction in the money supply (relative to, usually increasing, total national capital) than controlling rate of increase in the money supply just by interest rates.
(iv) Much tighter accounting rules, concerning the continually ongoing valuation of assets and reporting thereof. This looks to me to be the main area where others seek improvements, though, in all naturalness (and as previously), directors and major shareholders will always seek, and at least partially achieve, weakening of such rules over time - usually through arguments of lack of necessity and of inefficiency - with success through government ministers and members of parliament lacking in personal experience of the earlier disasters and, it seems, natural prudence in fairly evaluating the causes of introduction of previous accounting constraints.
As an aside:
(v) Concerning overall UK Government policy, as I think others have pointed out, it is rather strange to evaluate inflation by removing from the index, the single largest expenditure of just about every person in the land: the cost of a home to live in (whether it be owner-occupied or rented).
Best regards