Friday, 11 February 2011

Mervyn King: From Bagehot to Basel, and Back Again

An American friend sent along the New York Times hatchet job on Mervyn King. It is a classic of its genre. The first four sentences include the prejudicial phrases "should command respect", "has been accused", "has been condemned", and "has so far been ignored". Since little appears in the American Pravda by chance, one wonders what and whose agenda is served by such a one-sided and un-journalistic attack on a Governor who has done pretty well in preserving Britain's financial sector, economy and currency when basket cases surround Britain on all sides (westwards not excepted). No one quoted as critical of Mr King in the hatchet piece is a working banker, I note.

This little propaganda reminded me that I wanted to blog one of Mr King's bravest speeches. Perhaps bringing what he said to light will help to explain the animosity of those behind the whisper campaign.

Below are excerpts from a speech Mervyn King gave at the Second Bagehot Lecture Buttonwood Gathering, New York City, October 2010. He had me from the mention of Bagehot in the title, but just the first few paragraphs will tell you why he lost Wall Street and Washington. He directly challenges "extend and pretend" as a solution to the crisis:

Banking: From Bagehot to Basel, and Back Again


Walter Bagehot was a brilliant observer and writer on contemporary economic and financial matters. In his remarkable book Lombard Street, Bagehot brought together his own observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique of central banking as practised by the Bank of England and a manifesto for how central banks could handle financial crises in future by acting as a lender of last resort. The present financial crisis dwarfs any of those witnessed by Bagehot. What lessons can we draw from recent and current experience to update Bagehot’s vision of finance and central banking?

Surely the most important lesson from the financial crisis is the importance of a resilient and robust banking system. The countries most affected by the banking crisis have experienced the worst economic crisis since the 1930s. Output is somewhere between 5% and 10% below where it would have been had there not been a crisis. Unemployment is up, businesses have closed, and the direct and indirect costs to the taxpayer have resulted in fiscal deficits in several countries of over 10% of GDP – the largest peacetime deficits ever.

The Practice of Banking

At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system. Other parts of the financial system in general functioned normally. . . .

For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years, bank balance sheets have grown so fast that today they are over five times annual GDP. The size of the US banking industry has grown from around 20% in Bagehot’s time to around 100% of GDP today. And, until recently, the true scale of balance sheets was understated by these figures because banks were allowed to put exposures to entities such as special purpose vehicles off balance sheet.

Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing concentration: the largest institutions have expanded the most. . .

Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960. . . .

While banks’ balance sheets have exploded, so have the risks associated with those balance sheets. Bagehot would have been used to banks with leverage ratios (total assets, or liabilities, to capital) of around six to one. But capital ratios have declined and leverage has risen. Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part by the expansion of trading books (Brennan, Haldane and Madouros, 2010).

And banks resorted to using more short-term, wholesale funding. The average maturity of wholesale funding issued by banks has declined by two thirds in the UK and by around three quarters in the US over the past thirty years – at the same time as reliance on wholesale funding has increased. As a result, they have run a higher degree of maturity mismatch between their long-dated assets and short-term funding. To cap it all, they held a lower proportion of liquid assets on their balance sheets, so they were more exposed if some of the short-term funding dried up. . . .

Moreover, the size of the balance sheet is no longer limited by the scale of opportunities to lend to companies or individuals in the real economy. So-called ‘financial engineering’ allows banks to manufacture additional assets without limit. And in the run-up to the crisis, they were aided and abetted in this endeavour by a host of vehicles and funds in the so-called shadow banking system, which in the US grew in gross terms to be larger than the traditional banking sector. . .

The size, concentration and riskiness of banks have increased in an extraordinary fashion and would be unrecognisable to Bagehot. Higher reported rates of return on equity were superficial hallmarks of success. These higher rates of return were required by, and a consequence of, the change in the pattern of banks’ funding with increased leverage and more short-term funding. They did not represent a significant improvement in the overall rate of return on assets. Not merely were banks’ own reported profits exaggerating the contribution of the financial sector to the economy, so were the national accounts. . . .

Moreover, a financial sector that takes on risk with the implicit support of the tax-payer can generate measured value added that reflects not genuine risk-bearing but the upside profits from the implicit subsidy. And even without an implicit subsidy the return to risk-bearing can be mismeasured. It is widely understood that an insurance company should not count as profits the receipt of premia on an insurance policy that will pay out only when a low-frequency event occurs at some point in the future. But part of the value added of the financial sector prior to the crisis reflected temporary profits from taking risk and it was only after September 2008 that much of that so-called economic activity resulted in enormous reported losses by banks.

It is possible to make a very rough estimate of the possible size of this distortion in the reported financial sector output data. If we assume that true labour and capital productivity in the financial services industry grew in line with that in the wider economy in the 10 years prior to the crisis, then, given the inputs of capital and labour over that period, the official estimate might have overstated UK financial sector value added by almost £30 billion up to 2007 – around half of the growth in the official measure. . . .

The theory of banking

It is this structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer. . . .

For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.

Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. . . .

Finding a Solution

The guiding principle of any change should be to ensure that the
costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation. All proposals should be evaluated by this simple criterion.

The first, and most obvious, response to the divergence between private benefits and social costs is the imposition of a permanent tax on the activity of maturity transformation to “internalise the externalities”. Such a tax, or levy, has been discussed by the G7, and introduced in the UK. . . .

Why Basel III is not a complete answer

Basel III on its own will not prevent another crisis for a number of reasons.

First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee. . . .

One criticism of Basel III with which I have no truck is the length of the transition period. Banks have up to 2019 to adjust fully to the new requirements. Although some of the calculations of the alleged economic cost of higher capital requirements presented by the industry seem to me exaggerated (Institute of International Finance, 2010), I do believe that it is important in the present phase of de-leveraging not to exacerbate the challenge banks face in raising capital today. Banks should take advantage of opportunities to raise loss-absorbing capital, and should recognise the importance of using profits to rebuild capital rather than pay out higher dividends and compensation.

Large Institutions

The implicit subsidy to banks that are perceived as “too important to fail” can be
important to banks of any size but is usually seen as bigger for large institutions for which existing bank resolution procedures either do or could not apply. Moreover, most large complex financial institutions are global – at least in life if not in death. . . .

Solving the “too important to fail” problem will require ultimately that every financial sector entity can be left to fail without risk of threatening the functioning of the economy. . . .

More Radical Reforms

One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher. . .

Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009). . . .

The advantage of these types of more fundamental proposals is that no tax or capital requirement needs to be calibrated. And if successfully enforced then they certainly would be robust measures. . . .

Of all the many ways of organising banking, the worst is the one we have today.


I have explained the principles on which a successful reform of the system should rest. It is a program that will take many years, if not decades. But, as Bagehot concluded in Lombard Street, “I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.”

At a time when bankers are keen to supersize bonuses and dividends, based on massively relaxed accounting and transparency standards and a huge public subsidy, Mervyn King reminds us that any so-called "profits" are the result of alchemy that socialises losses to the taxpayers and inflation-hit masses of the world.

He demands more equity capital, no public subsidy, division of systemically important functions from TBTF banks so that they can be left to fail, curbing of dividends while banks rebuild balance sheets and other policies inimical to Wall Street, global banks and their puppets in the Fed.

Look at Bill Isaac's plea for higher bank dividends in the FT this week. Look at insider selling by bank executives. (hat tips to Barry Ritholtz and Simon Johnson) On suspects some executives are desperate to loot their banks before they fail again.

Gee, why would the New York Times want to question Mervyn King's authority just now? This couldn't stink more if it had Judith Miller's byline on it.

Wednesday, 2 February 2011


A Holding Company is a thing where you hand an accomplice the goods while a policeman searches you.
- Will Rogers, 1935

Plus ça change, plus c'est la même chose.

Egypt, China and Famine Futures

It's February already! When I was just 19 someone told me that when I turned 21 the speed at which time elapses would double, and then when I turned 45, it would double again. With January gone in a blink, the subjective acceleration of elapsed time is confirmed again. It makes me aware of how little time any of us have in our brief spans of life, and so how important it is to think forward to the future we help to create.

There are so many things I wanted to write about in depth, but perhaps what I need to do is just write something - especially since the comments may be the best part of this blog if the old Roubini posse hangs out here.

Along with the rest of the world, I am watching events unfold in Egypt and I am awed by the civilised and moderate nature of the Egyptian crowds. Students have formed protective rings around the most important heritage sites to prevent damage. Neighbourhood Watches have sprung up to provide civil security. Supplies of food and water are couriered to the protestors and shared with the police and soldiers. There is no obvious political leadership among the protesters, but their self-organisation is still impressive.

The looting that has occurred appears to have been a tactic of the security forces to prepare the way for an aggressive crackdown.

I wish it was only undemocratic regimes that used the technique of the agent provacateur, but there is too much evidence otherwise. Every post-9/11 group of "terrorists" arrested in the USA for bomb plots has had an FBI informant as the main agitator, planner and source of weapons or equipment. Here in the UK, we have police undercover agents infiltrating green and peace groups - sleeping with and even marrying activists - and they too foment unlawful violence. (It's worth clicking the link for the picture of the protestors in front of Scotland Yard.) At the G20 protests a couple years back, the peaceful crowd started to video an agitator and reported him to organisers and police, only to see him run for police lines and disappear among his colleagues. The agent provocateur has become a mainstream strategy of a political class which views organised, democratic resistance as a threat to entrenched privilege. The unscrupulous politician might even instigate violence to foment fear and justify further statist oppression.

A nation of 50 million Arabs is peacefully demanding democratic reforms and accountability. This is so starkly at odds with the narrative we have been fed by our leaders in the West that we should probably rethink what else they might have got wrong.

Now imagine if such activism spreads to China. I guarantee you that the Chinese elites are imagining it too. In a country where food and fuel take about half the money in the average consumer wallet, the risks of political instability from rising inflation are very real.

The monetary excressences of the central banks to maintain the dividends and bonuses of their corporate cronies are going to spur a political backlash as inflation takes hold. The Chinese elites, just like our own, have gained the disproportionate benefit of monetary laxity through their speculations in real estate and commodities. But now comes the inflationary backlash . . .

The current spike in food prices has exceeded the spike in 2008. Rice is limit up two days in a row. Storms and crop failures are threatening worse to come.

The role of public policy in worsening market failures in energy and food is worthy of deep and searching examination. As Barry Ritholtz points out, oil companies and agribusiness are among the top corporate welfare queens, sucking on the Treasury for subsidies while reporting huge profits largely secured from taxation by sweetheart tax breaks and global avoidance strategies. When real people go hungry, and many are unemployed, the offensiveness of this political and economic injustice becomes too great to stomach.

Egypt used to have a food surplus. Thanks to the miracles of modern agribusiness, population growth, and mismanagement by corrupt politicians, it is now a net importer of food. Food security is going to be a priority for any new leadership in Egypt. A recent UK study of food security makes clear that it is an issue we will all have a stake in resolving.

As the Year of the Rabbit dawns, China's elites will be weighing life without easy credit against life with political chaos and hungry protesters. I used to be quite confident that they would crack down on banks and the shadow banks that have grown like fungus in the warm, moist environment of monetary excess. Now I am not so sure. Like their peers in the banks, oil companies and agribusinesses of the West, many Chinese elites cannot imagine a world of financial constraint and fiscal austerity. Despite the risk that they could lose it all to political instability if they delay and inflation takes hold, they appear to be wavering.

Interesting times . . .

What is clear is that our systems for energy and food production and distribution have become so highly concentrated and so easily manipulated by the corporate few that a popular uprising might be the best hope of reform for the hungry many.

Professor Roubini has a piece in the FT today discussing the stagflationary risks of instability.

Writing this, I went back and read "Famine Futures" which I wrote in 2008. That post goes into more detail about how progressively more concentrated ownership of critical energy and food production, alongside free market reforms and financialisation of commodity markets, have led us to where we are.

What I don't know as I watch political change unfold, is where we go from here. I'm still thinking a few chickens in the back yard might be a good investment.

Update: Why US farm policy caused Egypt crisis, by Thomas Kostigen