“You know, I think we could do with a bit of a recession,” an investment banker told me the other day, as he prodded a sautéed diver-caught scallop with his fork. “We need to purge the system – get rid of all the excess.”
It’s a view I hear quite a lot around the City – and it’s a view that, to a certain extent, I share. Even so, it still jars when expressed by an employee of a bank that has just had to write off billions yet who began the conversation by telling you how pleased he was with last year’s bonus. In the unlikely event his job gets “purged” in a recession, I know he won’t have to worry how to pay for his TV licence.
Besides, bankers were responsible for the “excess” in the first place. If families are now worrying whether they can get a new mortgage, or why they have had their credit card withdrawn, it is because something went seriously wrong at the heart of the financial system. Banks were lending vast sums to people who should never have been given credit and the people in charge either didn’t understand what was going on, or were too deeply involved to put a stop to it.
But was this just a typical case of markets overheating, a typical response to external factors such as the pace of globalisation and Alan Greenspan’s mistaken decision to keep interest rates too low after the dotcom bust? Or does it signify deep structural flaws in the financial system: a crisis borne of “heads-I-win-tails-you-lose” incentives that encouraged people to take reckless risks? Of a system rife with conflicts of interest that allowed ratings agencies to be paid by the people they were supposed to rate? Of banking regulations and accounting standards that encouraged the shifting of risks off balance-sheet?
In other words, is the answer to this crisis – as my companion implicitly suggested – a recession that gets rid of bad practices and wipes the slate clean? Or are the problems so deep-rooted that full reform of the financial system is required?
The best argument in favour of the system being rotten is in bankers’ bonuses – clear evidence that incentives in the markets are badly skewed. The “originate and distribute” model of banking, whereby banks don’t hang on to loans but parcel them up and sell them on, was a recipe for bad lending. Meanwhile, the “two-and-twenty” management and performance fee structures used by hedge funds and private equity firms gave investors a huge share in profits without forcing them to share any losses.
There is a distinguished body of thought that says since banks are vital to the healthy functioning of the economy they should be regarded as utilities and regulated as such. To force banks to reform, governments would have to be willing to allow banks to fail – and no government will take that risk, as we have seen. If governments must always pick up the pieces, they should make rules to stop banks running stupid risks.
I don’t think this view works either, in theory or in practice. Politicians aren’t very good at working out what are stupid risks, but markets are pretty good at weeding out bad practices after a shock. If people have lost faith in ratings agencies, the answer is not for bureaucrats to tell them how to do their jobs in future, but for the agencies to change their ways. If investors think that hedge funds and private equity groups are taking stupid risks with their money, they won’t give them any money.
Already this year we have seen ratings agency Moody’s reform its rating system, while the UK hedge fund industry has just released a sensible voluntary code of practice. And shareholders are now starting to demand changes to the way bankers are rewarded.
Besides, heavy-handed clampdowns often do more harm than good. Capital is so mobile and capital markets so creative that the result is often to drive business elsewhere. The main impact of the US Sarbanes-Oxley Act in the wake of the dotcom crash was to help London steal a march on New York. And since no two financial crises are the same, nothing governments do when one bubble bursts will prevent the next one blowing up somewhere else in the financial system.
Even so, rational argument won’t determine whether there is a regulatory clampdown. If the crisis gets worse and the mood turns against the banks, politicians may feel compelled to act. Bankers should beware public opinion – particularly when they’re explaining why a recession might not be a bad thing.
A fitting award
How fitting that Sir John Rose should have been honoured as a “Great Briton” at last week’s Morgan Stanley awards. The Rolls Royce boss has done quite a job over the past decade – even if he attributes much of this success to his team.
But the award is a timely reminder that it pays to have manufacturing companies, employing skilled engineers to make things the world needs. Sir John has often seemed a lone voice warning about the dangers of losing British engineering skills. Perhaps this award – from a bank at the centre of a financial crisis – is evidence he is being heard.
Simon Nixon is executive editor of Breakingviews.com