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<p class="MsoNormal"><br></p>
<p class="MsoNormal">When<span style=""> </span>the Governor of
the Bank of England , says,</p>
<p class="MsoNormal">“Of all the many ways of organising banking,<span style=""> </span>the worst is the one we have to-day.”</p>
<p class="MsoNormal">We should sit up.</p>
<p class="MsoNormal">Thanks to<span style=""> Richard Chisnall </span>we can read the full speech on the web.</p>
<p class="MsoNormal">Thanks to<span style=""> </span>the
past lectures of two government economists ,Professor Peacock and Cairncross, and
John Mackintosh later to be an M.P . and five years<span style="">' </span>tuition at Edinburgh Uni-<span style=""> </span>which our society , not I, paid for,<span style=""> </span>I am able to pass on to you a précis of
Mervyn King’s 13,000 word lecture in New York in 1300 words.<span style=""> </span></p>
<p class="MsoNormal">We live in a different world now- as a banker said last
week.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">Speech by Mervyn King<span style="">
</span>25<sup>th</sup> October, 2010 </p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">Mr King<span style=""> </span>refers to
Walter Bagehot<span style=""> </span>“ a brilliant observer on
contemporary and financial matters”<span style="">
</span>and<span style=""> </span>divides his speech into
four,<span style=""> </span>an Introduction,<span style=""> </span>the Practice of banking, <br></p>
<p class="MsoNormal">The Theory of banking<span style="">
</span>and he <span style=""> </span>ends with, Finding a
solution.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">First. The present banking crisis dwarfs anything
experienced by Bagehot. The worst since 1930’s . At the heart is the expansion
and then the contraction of the banks’ balance sheets.</p>
<p class="MsoNormal">The lesson is the importance of the resilience of the
banking system.</p>
<p class="MsoNormal">Not even massive injections<span style="">
</span>of both<span style=""> </span>liquidity and capital by
the state<span style=""> </span>could prevent a devastating
collapse of confidence<span style=""> </span>and output
throughout the world.</p>
<p class="MsoNormal">So we need an answer how to make the system more stable.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">Second<span style=""> </span>King describes
the Practice of Banking</p>
<p class="MsoNormal">Since Bagehot wrote “Lombard Street”
the banking sector first exploded (in size) and then the risks exploded in size
.</p>
<p class="MsoNormal">The sector<span style=""> </span>was
broadly stable at<span style=""> </span>half of GDP<span style=""> </span>… a ratio - banking to GDP of 1:2<span style=""> </span>but now (after the growth over the last fifty
years)<span style=""> </span>to a ratio<span style=""> </span>of 5 :1.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">Then the risks associated with banking exploded .and the
banks were allowed to cover them up by putting exposure to the risks off
balance sheet. </p>
<p class="MsoNormal">The rate of expansion was accompanied by concentration of
power (which ,surprisingly, King finds ‘surprising’)<span style=""> </span>-in UK
the asset holdings of the top ten banks amount to<span style=""> </span>450% of GDP,</p>
<p class="MsoNormal">And RBS, Barclays and HSBC each individually having assets
in excess of UK GDP </p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">Also assets to liabilities ratio has declined<span style=""> </span>, before tehcrash “leverage has increased to
astronomical levels “</p>
<p class="MsoNormal"><span style=""> </span>Also banks resorted
to using short term (vulnerable) funding .so maturity declined by two thirds.</p>
<p class="MsoNormal">To cap it all they held a lower proportion of<span style=""> </span>liquid assets on their balance sheets. So
were more exposed if short tem funding dried` up .</p>
<p class="MsoNormal">Also<span style=""> </span>by financial engineering
banks were allowed to<span style=""> </span>manufacture
additional assets<span style=""> </span>without limit.</p>
<p class="MsoNormal">Also they were abetted by ‘vehicles’ in the<span style=""> </span>so called ‘shadow banking’ system.,</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">The Consequences</p>
<p class="MsoNormal"><span style=""> </span>First<span style=""> </span>the financial system was enormously more
inter-connected which makes it more difficult to regulate since chains of
transaction make it more difficult to locate in one institution. </p>
<p class="MsoNormal">Second<span style=""> </span>gross balance
sheets are not related to the<span style=""> </span>scale of
the real economy.</p>
<p class="MsoNormal">So panic sets in.</p>
<p class="MsoNormal">“The size, concentration and riskiness of banks<span style=""> </span>have increased in an extraordinary fashion.”<span style=""> </span>Banks reported profits were exaggerated. ..in
UK…by a
measured 100% . Financial intermediaries add value but not as much<span style=""> </span>as the statistical convention would suggest. </p>
<p class="MsoNormal">The financial sector takes on<span style=""> </span>risk with the implicit support of the<span style=""> </span>tax-payer. And makes private profits
from<span style=""> </span>the implicit subsidy.</p>
<p class="MsoNormal"> </p>
<p class="MsoNormal">THE THEORY OF BANKING</p>
<p class="MsoNormal">Banks are very risky because they<span style=""> </span>rely too much on borrowing<span style=""> </span>short term. <Long term equity holders
cannot cut and run so<span style=""> </span>easily . Banks are
also risky becausae they<span style=""> </span>are highly
leveraged – they take on<span style=""> </span>more highly
profitable debt than their<span style=""> </span>equity
holdings suggest is wise. And when they become illiquid they can be seen as
insolvent. </p>
<p class="MsoNormal">This in<span style=""> </span>turn<span style=""> </span>means that allowing them to borrow from the
central bank doesn’t solve their<span style="">
</span>problem. Banks behave as if they believe in alchemy.<span style=""> </span>And to work, financial alchemy requires<span style=""> </span>the implicit support of the tax-payer.</p>
<p class="MsoNormal"><span style=""> </span>And ends with
interrupting the<span style=""> </span>functioning of the
economy – payments, money, and<span style=""> </span>the
provision of capital, so<span style=""> </span>Government
cannot sit idly by since institutions are too bi9g to fail. Everyone knows it. </p>
<p class="MsoNormal"><b style="">..highly risky
banking institutions<span style=""> </span>enjoy implicit
public sector support` . In turn public<span style="">
</span>support<span style=""> </span>incentivises banks to
take on yet more risk </b></p>
<p class="MsoNormal"><b style="">knowing that if things
go well<span style=""> </span>they will reap the rewards while
the public sector will foot the bill<span style=""> </span>if
things go wrong.</b></p>
<p class="MsoNormal">There was a descent into hubris. It was an accident waiting
to happen<b style=""> </b>.</p>
<p class="MsoNormal">.... uncertain value of bank assets… Achilles heel…. Absurd…
dubious claims.</p>
<p class="MsoNormal">Finding a solution</p>
<p class="MsoNormal">The guiding principle should be the costs of<span style=""> </span>crises should fall<span style=""> </span>on those who enjoy the benefits of
“maturity<span style=""> </span>transformations”<span style=""> </span><span style=""> </span></p>
<p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.25in;"><span style="">a)<span style="font: 7pt "Times New Roman";"> </span></span>impose
a<span style=""> </span>permanent tax<span style=""> </span>on maturity transformation* a levy as
discussed at G7.</p>
<p class="MsoNormal">On the principle that the polluter pays- fixing the price of
the levy will be difficult.</p>
<p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.25in;"><span style="">b)<span style="font: 7pt "Times New Roman";"> </span></span>Control
the quantity<span style=""> </span>of leverage etc,<span style=""> </span>set capital standards.. ( –a concordat was
achieved in September at Basle.)</p>
<p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.25in;"><span style="">c)<span style="font: 7pt "Times New Roman";"> </span></span><span style=""> </span>Ring fence those activities most
concerned<span style=""> </span>so <span style=""> </span>the cost of financial failure would be
reduced. </p>
<p class="MsoNormal">Yet Basle lll is not the complete
answer.<span style=""> </span>It is only a small step and will
not prevent another crisis.</p>
<p class="MsoNormal"><span style=""> </span>Because<span style=""> </span>accepted capital rations fail to<span style=""> </span>predict<span style="">
</span>which institutions would be vulnerable<span style="">
</span>. also ‘past experience’ failed to predict<span style=""> </span>what happened in 2008. Northern Rock<span style=""> </span>ran out of money within weeks of announcing
it intended to return capital to its shareholders.<span style=""> </span>Basle 11 was based on
a judgment that mortgages were the safest form of lending. irrespective of how
they were financed a model which then became unviable.</p>
<p class="MsoNormal">Banks should use profits to rebuild capital rather than pay
highertr dividends and compensation . Fixing<span style="">
</span>a permanent tax on maturity transformations is vital. <span style=""> </span></p>
<p class="MsoNormal">Because it tries to induce stability by<span style=""> </span>building assets when the difficulty is
assessing risk.</p>
<p class="MsoNormal">Because Basle ll looks at banks’
balance sheets when the risks are off balance sheet.</p>
<p class="MsoNormal">And ignores banks’ vulnerability to illiquidity<span style=""> </span>which can induce failure.</p>
<p class="MsoNormal">The B of E will not ask banks to build up assets faster, it
is a long term<span style=""> </span>task.</p>
<p class="MsoNormal"><b style="">“We need radical
reforms”<span style=""> </span></b></p>
<p class="MsoNormal"><b style=""> </b></p>
<p class="MsoNormal">On LARGE INSTITUTIONS</p>
<p class="MsoNormal">“Solving the ‘too important to fail’ problem will require
ultimately that every financial sector entity can be left to fail without risk
of threatening<span style=""> </span>the functioning of the
economy.<span style=""> </span>In many countries big steps
forward have been taken.</p>
<p class="MsoNormal">There needs to be<span style="">
</span>restrictions on the maturity structure of its liabilities.</p>
<p class="MsoNormal"><span style=""> </span><span style=""> </span></p>
<p class="MsoNormal">MORE RADICAL REFORMS</p>
<p class="MsoNormal">One simple solution advocated by David Miles<span style=""> </span>would be much higher levels of capital<span style=""> </span>require by several orders of magnitude.<span style=""> </span>Leading to the proposal to introduce
‘limited purpose banking’ (Kotlikoff) <span style=""> </span>This cuts out alchemy. It needs studying.<span style=""> </span>Functional separation is another
proposal<span style=""> </span>divorcing payments from risky
lending activity. <span style=""> </span>That is to prevent
fractional r3eserve banking<span style=""> </span>(see Tobin
etc)</p>
<p class="MsoNormal"><b style="">In essence these
proposals<span style=""> </span>recognize that if banks undertake
risky activities it is highly dangerous to allow<span style=""> </span>such gambling to take place<span style=""> </span>on the same balance sheet<span style=""> </span>as is used to support the payments
system<span style=""> </span>and other vital parts of the financial
infrastructure.<span style=""> </span>Genuinely safe deposits
should not co-exist with<span style=""> </span>risky assets. </b></p>
<p class="MsoNormal">A key challenge is to ensure the<span style=""> </span>maturity transformation does not migrate
outside the<span style=""> </span>regulated perimeter.<span style=""> </span>, an end upp benefiting from the implicit
public subsidy.- which is the nature of these services.<span style=""> </span>And so difficult. </p>
<p class="MsoNormal"><b style="">Suppliers of funds
muist understand they willl not be protected.<span style="">
</span>Fromloss by the tax-payer. Creditors must know they may bear losses.</b></p>
<p class="MsoNormal"><b style=""> </b></p>
<p class="MsoNormal"><b style="">FINAL PARAGRAPHS </b></p>
<p class="MsoNormal"><b style="">The broad answer is
likely to be<span style=""> </span>remarkably simple.<span style=""> </span>Banks should be financed much more heavily by
equity<span style=""> </span>rather than by short term debt.
Much much more equity. <span style=""> </span>Risky investments
cannot be financed in any other way.</b></p>
<p class="MsoNormal"><b style=""> </b></p>
<p class="MsoNormal"><b style="">“Of all the many ways<span style=""> </span>of organising banking,<span style=""> </span>the worst is the one we have to-day.”</b></p>
<p class="MsoNormal">There is no simple answer to the<span style=""> </span>“too important to fail” nature of banks. </p>
<p class="MsoNormal">“I have explained the principles on which<span style=""> </span>a successful reform of the system should
rest.<span style=""> </span>It will take many years. <span style=""> </span>To quote Bagehot “</p>
<p class="MsoNormal">“I have written in vain, if I require to say now that the
problem is delicate, the<span style=""> </span>solution is
varying and difficult,<span style=""> </span>and that the
result is inestimable<span style=""> </span>to us all.” </p>
<p class="MsoNormal">COMMENT</p>
<p class="MsoNormal">The banks with their ‘hubris ’ are already opposing King, have
continued payment</p>
<p class="MsoNormal">Of<span style=""> </span>bonuses<span style=""> </span>to traders (some of them in cash now some in
shares).<span style=""> </span>The Government has recently
announced the intention of reducing the regulatory regime, not increasing it as
King suggests.<span style=""> </span>So<span style=""> </span>how is control of<span style=""> </span>these corporation to be exerted?</p>
<p class="MsoNormal">Just three banks, as King reports, each have<span style=""> </span>a greater capitisation than the UK Gross
Domestic Product.</p>
<p class="MsoNormal">My proposal is<span style=""> </span>to cut
corporations down to person size. By imposing a variable but renewable
termination date<span style=""> </span>to each
corporation<span style=""> </span>which as we so often
overlook, has been granted corporate existence by society . The threat of
bringing forward their termination date will encourage compliance.</p>
<p class="MsoNormal">James </p>
<p class="MsoNormal"><span style=""> </span></p>
<p class="MsoNormal"><span style=""> </span></p>
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