Monte dei Paschi di Siena - we've been here before
In June, the Italian Parliament approved Italy’s struggling third-largest lender, Banca Monte dei Paschi di Siena (MPS), for another round of state aid. This week, Reuters reports the Italian state may have to take a stake in the bank after it posted larger than expected first-half losses of €1.6 billion. MPS’ ongoing difficulties stem from imprudent lending and acquisitions during both the Europe-wide credit expansion and the “consolidation frenzy” which swept the Italian banking sector in the late 2000s, leaving it with low reserves compounded during the downturn by the bank’s €25 billion exposure to Italian government bonds – described as “proportionally higher than that of its domestic peers”.
One other interesting piece of information: founded in 1472, the Sienese institution also happens to be the world’s oldest surviving bank.
I say “surviving”, of course, because the city of Florence had a history of much older banks, many of which went bankrupt over a hundred years before MPS was even founded. Their story, recalled briefly in Jesús Huerta de Soto’s Money, Bank Credit and Economic Cycles, is worth revisiting here because it reveals a similar set of preceding circumstances:
“Around the end of the twelfth and beginning of the thirteenth centuries, Florence was the site of an incipient banking industry which gained great importance in the fourteenth century. The following families owned many of the most important banks: the Acciaiuolis, the Bonaccorsis, the Cocchis, the Antellesis, the Corsinis, the Uzzanos, the Perendolis, the Peruzzis, and the Bardis. Evidence shows that from the beginning of the fourteenth century bankers gradually began to make fraudulent use of a portion of the money on demand deposit [ie. non-saving deposits], creating out of nowhere a significant amount of expansionary credit. ... [A]n increase in the money supply (in the form of credit expansion) caused an artificial economic boom followed by a profound, inevitable recession. This recession was triggered not only by Neapolitan princes’ massive withdrawal of funds, but also by England’s inability to repay its loans and the drastic fall in the price of Florentine government bonds. In Florence, public debt had been financed by speculative new loans created out of nowhere by Florentine banks. A general crisis of confidence occurred, causing all of the above banks to fail between 1341 and 1346.” (pp. 70-71)
A familiar pattern emerges from de Soto’s work: banks drawn into excessive lending on ever-diminishing reserves, triggering in turn credit expansion, recession, and financial vulnerability compounded ultimately by over-exposure to questionable government debt.
It is a pattern which demonstrates a weakness in our current economic system that is older even than the oldest of its contemporary institutions. More properly, it is a cautionary tale against state collusion in the active encouragement of excessive lending and credit expansion. In the fourteenth century, this was achieved through the privileges granted to banks by their avid state-borrowers, allowing them ignore the earlier legal principle of maintaining full reserves on non-saving deposits. In the twenty-first century, however, the pattern of depletion was significantly amplified by the availability of easy lines of credit through the European System of Central Banks.
De Soto would argue, as he does in his conclusions, that the way to avoid the kind of insolvency crisis which struck medieval Florence and threatens modern Italy is a system of free banking (ie. without central bank interference), accompanied by full-reserve requirements on non-saving deposits. The efforts of the Italian government to boost MPS’ reserves aim to address an important weakness, but as long as the European Central Bank retains the capacity to expand credit artificially in the name of “stimulus”, the risk of state-induced asset bubbles and sovereign-debt crises still exists.
Although today we use the euro instead of the florin, those two issues are still very much two sides of the same coin.
Why Funding for Lending will not work in the long run
The Funding for Lending Scheme (FLS), introduced by the Treasury and the Bank of England at the start of this month, aims to encourage banks and building societies to lend to UK households and businesses by allowing them to borrow from the Bank of England for up to 4 years at lower rates. These rates would be based on the amount that the banks lend out. In theory, this would allow many entrepreneurs to start new businesses that would be unviable without these lowered rates, as well as getting first time buyers on the property ladder.
The scheme has been coolly received by lenders, largely because of the track record for bureaucracy involved in previous government schemes of this nature. There have also been criticisms from the media, namely, that there have been no stipulations as to whom banks can lend to in order to receive their reduced fees, meaning some banks are aiming the savings towards trusted borrowers rather than new investors. To the libertarian, this seems more of a cushion to further market distortion, as the government backing banks to lend to anyone regardless of their ability to repay is what got us into this mess in the first place.
History and the Austrian school of economics tell us that when interest rates are artificially lowered below the market rate, people will simultaneously save less and invest more, but do so with false information about the market, as price signals become relatively distorted. Business schemes that would have been unviable with the higher borrowing rates now seem attractive, and so time preferences (i.e. whether one should spend now or save now) change to favour increased spending. This has a knock on effect on those whom the increased capital in the economy is spent on, usually those who work in the capital goods industries, who also start spending and stop saving. Sooner or later it becomes clear that bad investments have been made based on artificially altered interest rates and nobody has any savings to fall back on.
Our state financial institutions continue to prolong this depression because they refuse to see that it is their continued inteference that is keeping us here. The FLS scheme is the latest in a long line of projects, seceding the National Loan Guarantee Scheme (NGLS), that hope to realign their fundamentally flawed Keynesian cross to boost output. The policymakers pat themselves on the back as economic activity increases, not realising that it is leading those members of society that could bring us out of recession into ruin based on the false information that they send out. As such, regardless of their good intentions, policymakers need to realise that these schemes are not the solution to our problems.
Let the market decide what happens to Libor
In a speech today, the head of the new Financial Conduct Authority (FCA), Martin Wheatley, will say that the structure and governance of Libor – the interest rate at which Britain's banks agree to lend to each other – is 'no longer fit for purpose and reform is needed'.
Nonsense. Libor works perfectly well. Like any other system, of course, it can be undermined by fraud – people deliberately trying to manipulate it in order to benefit themselves or their organisation. And as in any other system, the way to deal with that is to prosecute the wrongdoers for fraud. A few people facing fines or imprisonment for such misdeeds then encourages the others to guard their own probity.
And in the case of Libor, such prosecutions should not stop at the foot-soldiers who deliberately misrepresented their own banks' credit status to get better terms. They should include any executives who connived in the fraud – and indeed any officials in government and regulatory agencies who deliberately encouraged such misrepresentations. And indeed any politicians who might have given orders to do so.
Getting Libor right is important, because it is a key market indicator of how sound people believe our banks are. It might well suit politicians, officials and bank executives to suggest that things are rosier than they are, but that remains a deception and must be prosecuted as such.
Tearing up Libor would have further consequences, because so much financial business, so many financial products in wide circulation, are priced in line with it. And what would 'reform' involve. I can see it now: some panel of bureaucrats from a new and untested regulatory authority, collecting vast amounts of information from the banks (at huge expense), and pretending to sift through it all, from day to day, in order to establish some 'objective' borrowing rate. But I don't think that bureaucrats would be any better at that than they would be at deciding the price of strawberry ice-cream.
Politicians and officials, through more of a decade of over-borrowing, keeping interest rates too low, printing money and doing anything else they could think of to create an apparent boom, in fact created a fantasy land in which everyone – home-owners, borrowers, consumers and indeed bankers – did some pretty stupid things. Not surprisingly, people tried to blag their way out of trouble.
When that blagging turns into deliberate misrepresentation, which could create real financial losses for millions of ordinary holders of loans and pensions, that is fraud and should be treated as such. You need to go back to the root causes of the problem, and to make sure that politicians and officials no longer have the power to debauch our currency and abuse the public finances, and also to prosecute anyone who, even in such a fantasy world, engaged in straight fraud. What you certainly do not want is to replace markets with bureaucrats.
The time bomb keeps ticking
Last Saturday’s Wall Street Journal (US edition) carried an essay by David Wessel, author of the forthcoming book, “Red Ink: Inside the High-Stakes Politics of the Federal Budget”. It provides an excellent breakdown of the budget crisis looming over the US federal government.
Perhaps the most striking fact contained in the essay is that 63 percent of the US federal budget is on auto-pilot: “Social Security benefits get deposited. Health-care bills for Medicare for the elderly and Medicaid for the poor are paid. Food stamps are issued. Farm-subsidy checks are written. Interest payments are dutifully made to holders of Treasury bonds.” In technical jargon, this is non-discretionary spending – unless Congress actively stops it, such spending continues every year without the need for any further authorization. Throw in an ageing population and inexorably rising healthcare costs, and it becomes clear that such spending is only heading in one direction – skywards.
What is most worrying is that the US federal government currently only funds 66 percent of its spending through taxes. For the rest, it has to borrow. And while that may be bearable in the short-term, as nervous investors around the world pile into US Treasuries and push bond yields to record lows, it spells big trouble in the medium- to long-term. Every cent the government borrows now means more debt interest payments – and even more non-discretionary spending – in the future.
For an idea of just how bad it could get, take a look at this 2010 working paper from the Bank of International Settlements (BIS). Its projections indicate that without a policy shift, US public debt would rise to more than 400 percent of GDP by 2040. That would translate into annual debt interest payments equaling 23 percent of GDP – well in excess of total federal tax revenues, which have averaged a little over 18 percent of GDP since the Second World War. Such a scenario is plainly impossible: the US would be forced to default on its obligations long before things reached that point.
The policy implication here is straightforward enough: non-discretionary spending programs like Social Security, Medicare and Medicaid need urgent, drastic reform to put them on a more sustainable footing. The problem is politics: neither party is really serious about dealing with this fiscal time-bomb. Politicians’ electorally-driven time horizons are just too short to permit the sort of significant, structural changes that are required. Perhaps a rise Treasury yields will force the issue. Maybe another showdown over the debt ceiling will do the trick. But I won’t be holding my breath. As Detlev Schlichter puts it, when it comes to debt, governments around the world are determined to “extend and pretend”. Sadly, it is only a matter of time before reality catches up with them.
Tom Clougherty is managing editor at Reason Foundation, a libertarian think tank with offices in Los Angeles and Washington, DC. This article was originally published at reason.org.
The FSA swansong
The Financial Services Authority is due to pass into oblivion at the end of the year and not before time. Now according to Patrick Jenkins and Caroline Binham (Financial Times 19th July), goaded by public furore, it is going to step up its investigation into Libor manipulation. Some may think that is better late than never. The FSA is now, finally, about to pursue more companies and “more individuals will also be studied as a result”. This is the wrong way round.
Conduct is a matter of personal responsibility: penalties for malpractice should fall on culpable individuals. Only then should their employers be considered for further penalties. The public has been outraged by the lack of personal prosecutions in the banking sector. As our report “Simple Rules for Complex Systems: Streamlining the UK’s Financial Regulation Regime” published last week, puts it: “There is the confusion over whether individuals should be penalised, or their employing firms. In the Libor case, for example, the Barclays fine really only hurts the shareholders, who are completely innocent; whereas the wrongdoers retain their bonuses and, in many cases, their jobs. Penalties would be much more effective if they were targeted at individuals and not firms, except where the regulators and prosecutors can show that almost all the management were involved.”
Fining the Royal Bank of Scotland, as seems likely, would be especially ridiculous as it would merely transfer funds from one public purse to another.
It was only on the 6th July this year that the Serious Fraud Office decided to investigate whether any crimes had been committed. In other words, they have finally got around to investigating whether they should investigate.
All this is more than a little late.
The FSA failed to intervene and detect the manipulation in 2008 when the British Bankers Association was sufficiently worried to conduct an investigation. That turned out to be a whitewash with Barclays’ compliance people not bothering to show up. The point, though, is that the FSA should have conducted the investigation then, not the bankers’ trade union.
In 2011, the FSA reassured Bob Diamond, we are told, that they had been looking into Libor since 2009 and there was nothing much to worry about. We now know that the 2008 “investigation” and the eventual revelations this year were all down to digging by US and Canadian regulators, not the FSA. Note that the Barclays fines by US regulators were twice as high as those imposed by the FSA.
The FSA grumbled about Barclays management style but that is beside the point. Clearly the Libor rigging required more than one bank so the management style of any one of them is neither here nor there. Indeed, a sensible regulator faced by an uncooperative regulatee would immediately suspect that said regulatee was hiding something and redouble its enquiry.
The FSA’s approach to bank regulation has been useless. They have only come to life when prompted by public opinion or North American regulators. Chairman Lord Turner of Makebelieve was appointed to invigorate the FSA following its dismal lack of performance in the run up to the 2007 financial crisis. In all fairness some improvements have been made and that includes personal prosecutions for insider trading, but not in the banking sector.
In the new, post-FSA order, the Bank of England with its subsidiary the Prudential Regulatory Authority, will recover responsibility for policing the banks. Sir Mervyn King will be leaving and Lord Turner has been rumoured to be his successor. Heaven forbid.
How to streamline City regulation
The Financial Services Authority grew significantly in the 2000s, to 4,000 staff. But its tick-box approach to regulation took its focus off fundamental issues and it was unprepared for the unfolding financial crisis. Hence George Osborne’s decision to replace it with new agencies, the Financial Conduct Authority (FCA) for consumer protection and the Prudential Regulatory Authority (PRA) to supervise financial firms.
It is a mistake to have two regulators, second-guessing each other. They intend to be continuously monitoring financial firms, rather than just setting broad rules and punishing transgressions, which will increase the volume and cost of regulation on the sector. They also seem to have no understanding of the value of competition in regulating firms’ activities; and their high regulatory cost will not encourage new firms to set up.
The FCA seems to believe that it can train new staff in a matter of months, and specify in detail how firms in a complex sector should compete. It has provided no performance measures by which its success or failure could be judged.
A better model for consumer protection is the Financial Ombudsman Service (FOS), which sets broad rules and deals with hundreds of thousands of complaints on a staff of just 1,000. The FOS could protect consumers well, without the need for a further regulator in the form of the FCA.
The Bank of England has recovered its supervisory role. In this, it must not be diverted into the bureaucratic tick-box culture of the FSA.
The Prudential Regulatory Authority is conflicted between saving troubled firms and ensuring the health of the financial system as a whole, which will require some firms to fail from time to time. Early signs are that it does not appreciate the regulatory role of auditors, shareholders and boards and will load more unnecessary bureaucracy and cost onto companies.
Where malpractice is found, there is confusion over whether individuals or firms should be penalised. Targeting individuals would be more effective. Auditors should also face personal penalties for failure.
Libor malpractice does not require endless committees and investigation. The solution is quite simple. What should happen is that the firm contracted by the British Bankers Association to consolidate the figures should also be contracted to collect the data from their sources and ensure their probity, .e.g. by checking claimed interest rates by payers with payees. In other words, the role of the submitters should be taken out of the bankers’ network.
The heavy price of French participation in the 2010 G20 meeting in London was to hand financial services rule-making to Brussels. We should ensure that EU-wide rules are enforced uniformly across the EU, and not gold-plated here.
George Osborne’s plan to replace the FSA actually makes things worse, with more overlapping and conflicting regulators and greater costs arising from the bureaucratic tick-box culture. Regulation would be stronger if it were simpler. With this in mind, we recommend:
• The FCA is unnecessary and should be wound up
• The PRA should be slimmed and become an early-warning team to inform other regulators.
• The Money Advice Service, set up from the FSA, should be commercialised or dismantled.
• Regulators must understand and accept the role of brands and competition in bidding up service and value levels. The importance of boards, shareholders and auditors must be strengthened too.
• EU financial regulation must be enforced equally across the EU.
• The Bank of England must resist regulatory creep in EU regulation.
• Auditors and executives must be personally accountable.
Market hypocrisy
It was nice to see so many of our politicians attacking Barclays’ Bob Diamond for distorting markets by manipulating Libor rates. Efficient markets are the bedrock for solid economic growth, and nobody defends free and open markets better than the Adam Smith Institute, so can we take credit for the politicians’ exuberant market fervour?
Alas, no. Many members of the Treasury Select Committee were simply grand-standing hypocrites because nobody manipulates markets more and urges others to do the same than that crowd hunkered down in Westminster and its various partners in crime.
Start with the mother of all market manipulations - quantitative easing by the Bank of England. Running the printing presses to buy up UK government gilts has slashed interest rates across the board, royally screwing honest savers, prudent investors and pensioners. Those absurdly low interest rates allow the government to escape more aggressive cost controls and steer precious capital towards mis-priced investments. Have any Committee members sent emails to anyone about this market manipulation?
Still in the bond markets, the scramble to shore up wobbly banks led to higher capital requirements. And what’s the definition for that higher capital? Yes, holdings of yet more government bonds – how convenient and how market distorting! Even Greek government bonds just a couple of years ago were judged worthy but now leave so many banks in deep doo doo. Are there plans by the Committee to interrogate those responsible for the rule then?
Then there’s the Jaws of market distortions – the unseen predator lurking below the surface, otherwise known as pension deficits. The biggest sharks in the water are the public-sector pensions, virtually entirely unfunded. After all, what is a pension but the return from long-term investments in the form of dividends, interest payments or perhaps rising tax revenues. The complete disconnect between productive investment and pension payments is an obscene market manipulation whose real costs are only beginning to be understood. Which heads will the Committee seek to roll?
All too mind-numbingly big to comprehend? Here’s an easier one. In our leafy suburb, there’s a four-bedroom detached house occupied by a reasonably comfortable retired couple who recently shipped a vintage sports car to America and back so they could tootle down Route 66 for a few weeks. The roof of their house is now graced with solar panels subsidised every which way from initial installation to higher electricity rates for the rest of us. As this year’s incessant rain pours down day after day, surely one Committee member could demand an appearance by the energy-market manipulators responsible for this travesty.
John Mann, a Labour MP on the Committee, huffed and puffed at Mr Diamond that “Either you were complicit or you were grossly negligent or you were grossly incompetent. That’s the only conclusion.” Indeed. The Committee members might try that line while looking in the mirror.
Why we really don't want State control of banks and their lending
I think we'd all agree that Britain's banking sector is not exactly covering itself in glory at present? From going bust (variously, from excessive lending to mortgages, from overpaying for a rival bank, by being caught in a wholesale banking run, no, no one went bust because of doing silly things in their investment banks) through to what I'm sure will turn out to be everybody fiddling Libor, it's not been a great few years. Yet let us not forget that there is no problem, no situation, which government cannot make worse.
Take, as an example, what is happening in Argentina.
Fernandez, a center-leftist, is embracing increasingly unorthodox economic policies as she seeks to sustain activity, which analysts say is vulnerable to insufficient credit.
"We're going to tell the 20 principal banks... they have the obligation to lend for production and for investment," Fernandez said in a televised speech.
"The central bank's going to establish the conditions," she said, adding that state-run banks should not have to shoulder the entire responsibility for business loans.
She said the loans would carry a maximum interest rate of the Badlar reference rate, which was 11.9pc per year for private banks in June, plus 400 basis points. The minimum loan period would be three years.
With inflation at 25% that's an immediate loss of some 30% for the lending banks. And just as a thought, who would want to be increasing the money supply, the availability of credit, when inflation is 25%? As Uncle Milt taught us, inflation is always and everywhere a monetary phenomenon after all.
Now we don't have anyone advocating this in the UK, not yet. But we do have plenty of people calling for a State owned investment bank. The only reason for such being to insist upon financing going to things which the market unadorned will not finance: that's the whole point of having the State part. And by definition if money is to be forced into politically approved lending then it will be at a lower price than the market will provide: the Argentinian point writ small.
For the problem to become as bad as it is in Argentina we would need our own policy to be determined by increasingly unorthodox leftists. Fortunately, such are limited to nef, Anne Pettifor, Richard Murphy, Neal Lawson, Compass, half the Trade Unions, Seumas Milne and a goodly portion of the Labour Party. I hope you find that as comforting as I do.
Back to the drawing board guys and gals
The great thinkers at the nef have insisted that we must reform the UK banking system in the following manner:
We need new institutions such as a Post Bank, Social Investment Bank, Green Investment Bank and new mutual, local and regional banks to provide a diverse, competitive and resilient banking system fit for the 21st century.
They and Compass organised the Good Banking Campaign which said:
The creation of a genuinely mixed and plural banking sector with far more choice for people than the present one-size-fits-all model with its few 'too big to fail' banks. Such a sector would for example include flourishing building societies, local and regional banks, green banks, a post bank run through the post office network, co-operatives and mutuals so that all sections and needs of society and business are properly catered for.
Lovely. Co-ops and mutuals, just get rid of that capitalist part, the shareholders, and everything will be well sweet. From the New York Times:
Spain’s three largest banks — Santander, BBVA and La Caixa — are not expected to request rescue financing.
Ah, something of a problem with the basic thesis then. For two of those three are the capitalist shareholding type banks. All the ones going bust and threatening to bankrupt the entire country are the local, regional, mutual or co-op type banks.
I'm all in favour of having a varied ownership structure for I really do believe in markets. Markets in forms of organisation just as much as in products or services. But to think that cuddly local organisations cannot cause problems is an error. Especially when, as in Spain, so many of them were subject to the "democratic control" of the local political classes.
Even The Guardian has got the point about the Spanish banks
The general tenor of the screaming about the British banking system comes, of course, from the general ignorance of those doing the screaming. Apparently it's this mixture of casino banking with retail that caused all the bank falling over syndrome. That and the general greed of shareholder driven banking which must also be curbed.
Except, of course, it wasn't either of them: RBS fell apart over an expensive acquisition too far, Northern Rock didn't even have any casino banking, HBOS just lent too much into the property boom and got stuck by the bust and Lloyds gor shafted by merging with HBOS. Several mutuals fell over from the property bust too: and Lehmans didn't even have a retail arm so couldn't have been brought down by the mixture of that with casino banking.
But whatever, it's not what is true that matters it is what people believe is true which does. And there's very definitely a movement (from points Compass, nef and other idiot lefties) that what we really need is to stop having this capitalist banking at all. We should have regional, perhaps mutual perhaps state owned, banks. Run by a mixture of stakeholders and very definitely including local politicians so that the wider interests of society can be considered: not just the demands of Mammon.
Which brings us to The Guardian on the subject of the Spanish banking system:
Chairmen were often unqualified politicians, with academic investigators finding a close relationship between the size of a bank's bad loan book and the inexperience, lack of qualifications and degree of politicisation of the chairman.
Neatly illustrating one of the basic points of agreement of all of us here at the ASI. We do not say that markets are perfect. We do however say that all too often, any alternative to a market is worse.
In English terms the Spanish caja system was run on the basis that when not Mayor of London Ken might drop in to run the Bank of London. Or in an area controlled by the other lot, Boris. With perhaps Lee Jasper or Seb Coe running the audit committee. And there really has been a serious proposal that Prem Sikka, Richard Murphy and Anne Pettifor should be on the board of one or more such mooted regional banks.
We don't say that the City is perfect but Spain shows how much worse the alternatives can be.