www.equilibrium-economicum.net

Monthly articles (English and French) on the theme "Querying economic orthodoxy"

No. 25 - January 2008

Bankers' Chernobyl

ANGUS SIBLEY

A golden rule, and woe betide the banker who doesn't heed it:
Never lend anyone money unless he doesn't need it.
Anon

Consumers are constantly bombarded with credit offers and unscrupulous advertising by the banks.
Andy Davie, press release by IVA.co.uk, leading UK personal debt website

There is an analogy between bank credit and nuclear power. Both are potent sources of energy, economic and electric respectively. Both are dangerous unless strictly controlled.

An unfashionable notion

In the mid-1980s I attended a lunch at which the guest of honour was Nigel Lawson, now Lord Lawson of Blaby, then Chancellor of the Exchequer in Margaret Thatcher's government. The Chancellor spoke for some time about current economic conditions, which left much to be desired; although the British economy was not particularly buoyant, inflation was accelerating, encouraged by a rapid increase in bank lending, even though rates of interest were high.

Accordingly, when Lawson invited questions, I enquired why the government was making no effort to restrain directly the inflationary growth of credit, but instead was simply hoping that painfully high interest rates would do the trick. After all, not so many years previously, it had been normal for the Bank of England to issue instructions from time to time to the commercial banks, in effect requiring them not to increase their lending by more than x% per annum.

Lawson's response was furious. Credit controls? What the hell do you think you are talking about? Don't you know that they have been obsolete for years? Don't you realise that they are impracticable in the modern environment of liberalised international lending? No way am I going to reinstate them!

This has been the prevailing attitude for many years now in most parts of the world. It is true, of course, that free movement of capital between countries makes it harder for a government to restrain bank lending to individuals and businesses resident in its territory. If, for example, banks established within Britain were instructed to restrain their lending, then British residents could doubtless borrow more from overseas banks not subject to British regulations.

But at present, governments hardly even try to restrain bank credit. British banks are regulated by a state agency, the Financial Services Authority. In the FSA's remit, deposit-taking is a "regulated activity"; but lending is not. Consumer credit is regulated (inadequately) by the Office of Fair Trading, but not mortgage lending

It seems that the government feels it has a duty to protect people from losing their savings by placing deposits in dodgy banks. But not from drowning in debt by borrowing from banks that lend too freely. This seems illogical. In reality, there is little doubt that governments, individually or collectively, would find ways of imposing restraints on bank lending if they really wanted to do so.

Liars and believers

Over the last thirty years or so, governments have lost the will to regulate credit. The free-market economists have told them, over and over again, that they must not do it. And, as our old friend Josef Goebbels so neatly put it, if you tell a lie often enough, in the end people believe it. Governments have come to believe the economists' lie, so they no longer wish to control credit. They therefore continue the chain of lies by telling us all, over and over again, that the job of credit control cannot be done; and most of us have come to believe that story. It tickled me no end to be ridiculed by Nigel Lawson for not believing it. Precisely as I had expected.

Yet it should still be possible for a government at least to regulate mortgage lending secured on property within its jurisdiction. The property cannot move to an unregulated offshore location! This type of credit is an important part of total lending operations; and undisciplined mortgage lending is, as we see all too clearly today, particularly likely to lead to serious problems. If mortgage finance is too freely available, house prices are driven up to excessive levels. House buyers take on too much debt; and if later they find they cannot cope with it, the consequences are especially nasty; the borrowers can lose their homes. Regulators could, if they so chose, do much to prevent this by insisting (as once they did) that banks do not lend on mortgage more than a certain percentage of the value of the property mortgaged.

But hear what Mark Boleat had to say (1) on this topic not long ago. He was for many years director-general of the Building Societies Association in the UK, so he should know his subject. Yet he trotted out the standard dogma of the free-marketeers, who are obsessed by the idea that government should make no effort to shield its citizens from the consequences of their own collective folly. While regulators may be tempted to set specific requirements in respect of loan-to-value ratios....it is far better that they confine themselves to ensuring that borrowers fully understand what they are taking on....

This is naive. Suppose that millions of people are pushing house prices to silly levels by borrowing too much, encouraged by banks who are eagerly competing to expand their share of the mortage market. Then I, Aberdonian that I am, might wish to evade the trend by refusing to pay a silly price for the kind of house I need, so that I do not have to borrow too much. But that is clearly impossible. I cannot buy without paying the going rate. An individual cannot buck the market, no matter how well he "understands what he is taking on", no matter how prudent and penny-pinching he may be. That is why it is a regulator's duty to seek to keep the market on an even keel. But it's no use telling that to people who think the market is God. Not even libertarian economists are arrogant enough to aspire to regulate God.

American experience

The Federal Deposit Insurance Corporation (FDIC) is the US government organisation which guarantees repayment of deposits to customers of insolvent banks. This body published ten years ago a fascinating study (2) of the troubles of the US banking industry in recent years. It begins with a chart showing numbers of bank failures year by year since 1935. Between 1945 and 1975, there were hardly any. But between 1980 and 1994 there were 1,617 failures, amounting to around 9% of the entire US banking sector, whether one reckons by numbers of banks or by balance sheet size.

Why this stark contrast between the thirty-year stability of the post-war period and the subsequent turmoil? The answer is simple. In the horrific depression of the early 1930s, thousands of American banks failed, and until 1934 (3) there was then no FDIC to bail out their customers. The consequences of so many severe personal and business losses, and the ensuing destruction of confidence, convinced American legislators and regulators that the financial system had to be tightly regulated and closely supervised. Therefore bankers were obliged to behave prudently or, perhaps we should say, deprived of opportunities and incentives to behave imprudently. Further troubles were thus avoided.

But then neo-conservatism arrived. Economists reared on the theories of Austrian academics, rather than on painful practical experience in a turbulent financial world, argued that the banks should have "freedom" rather than strict regulation. This would make them lean and fit rather than comfortable and fat; dynamic rather than cautious; competitive rather than co-operative; expansive rather than prudent. Under the influence of these economists the regulations, carefully crafted by people who knew from hard experience the dreadful consequences of financial mismanagement, were gradually dismantled. As the FDIC observes, deregulation...at the federal level prompted a number of states to enact similar, or even more liberal, legislation in a "competition in laxity".

No regulations, please; just guidelines

Until quite recently, property lending in the USA was subject to regulations which stipulated maximum loan-to-value (LTV) ratios. In 1935, the maximum was no more than 60%; it was raised modestly to 66% in 1955. But in the 1960s - the age of the birth of permissiveness - it began to shoot up towards new heights: 80% in 1964, 90% in 1970, even 100% in 1989. A few years later, it was felt that this was perhaps overdoing it; new guidelines adopted in 1993 recommend that loans on residential property should not exceed an LTV ratio of 90% unless the loan is supported by insurance or other collateral.

But these 1993 guidelines, unlike the earlier limits, are not regulations backed by the force of law. They are only guidelines, and the regulators have little power to enforce them. As American real-estate lawyer Michael Frachioni observes (4), although the regulators had proposed uniform regulations for real estate lending standards...commentators argued that adopting LTV percentages in a regulation would be unnecessarily rigid and could result in a constriction of credit. Thus the LTV ratios were adopted as part of guidelines, not regulations.

Today, the results of years of "guided" but unregulated lending are headline news. The damage to bank balance sheets has spread far beyond those of the fools who originated the bad subprime loans. That is the trouble with our brilliantly clever innovative financial techniques; in their eagerness to mitigate risks, the bad bankers can now distribute them in small pieces to all those others who, convinced that risks are opportunities for profit, are willing to take them on. Doubtful debt spreads faster than bird flu.

So now we are all heartily wishing that there had been some constriction of credit. Even some of the biggest and grandest American banks, even Citicorp, Morgan Stanley and Merrill Lynch, are having to go cap in hand to the goverment - in Morgan's case, to the Chinese government - to ask for more credit or more capital. Remember what I wrote last November about sovereign funds? Well, now the China Investment Corporation, a government-run fund, has subscribed bonds which are convertible into almost 10% of Morgan Stanley's equity. Citicorp and Merrill have raised capital from sovereign funds in Korea, Kuwait, Abu Dhabi and Singapore. Do Americans still abhor government investment in business?

Financial journalists worry us with fears of a new recession, even a rerun of 1929. One hopes that those foolish commentators who opposed LTV regulation in 1993 are now feeling thoroughly ashamed. But that does not seem very likely. Free-market true believers, all too often, are impervious to the facts of life.

Bankers and Reactors

If a financial meltdown prompts melodramatic comparisons with Chernobyl, it is not without good reason. There is a very real analogy between the credit system and a nuclear power station. The second is a potent and abundant source of electrical energy; the first is a great source of economic energy.

For most economic development requires credit in one form or another. If there were no credit, one could only set up a new enterprise by first accumulating (or inheriting) sufficient capital to cover all the start-up costs. In this environment, new business creation would be pretty subdued.

By contrast, where credit is abundant and easily obtained, growth can be very rapid, but may not be soundly based. A business that relies too heavily on borrowed money is unstable. A boom financed by excessive and careless lending can turn into a shattering bust.

There is no need to emphasise the importance of stringent control and regulation of nuclear power stations. But too many people still do not see the need for tight control and regulation of the credit system. Will we have to suffer an economic Chernobyl before they come to their senses?

* * * * *

1 Mark Boleat, Regulation of Mortgage Lending Institutions, in Housing Finance International (London, September 2003), page 7; see link.

2 Federal Deposit Insurance Corporation, History of the Eighties - Lessons for the Future (1997), vol. I, chap. 1, figure 1.1 and table 1.1; see link.

3 The FDIC was created by Congress in 1933 following a disastrous series of bank failures. Its operations began on 1st January 1934 and it has successfully prevented further losses of deposits by bank customers. In general, losses of up to $100,000 per depositor are covered in the event of a bank failure. Curiously enough, President Roosevelt was not in favour of this measure, but agreed to it in the face of strong pressure from both Democrats and Republicans in Congress.

Roosevelt objected on the ground of moral hazard, ie the belief that insurance might encourage bankers to lend recklessly. They might think that insurance would allow them to get away with their misconduct, even if it all went wrong. This argument, routinely advanced by neo-conservatives, is in my view flimsy. If a bank runs into difficulties, and therefore has to be rescued by the FDIC, then clearly the FDIC intervenes on its own terms. These can include dismissal of the executives whose imprudence or negligence got the bank into trouble. One can get rid of the bad bankers without destroying the bank. If the management acted under pressure from greedy shareholders, who demanded that big risks be taken in the hope of earning big profits, then the shareholders too can be punished. The bank can be recapitalised on terms that leave the pre-rescue shareholders with little value.

In fact, the FDIC's commonest method of rescue is to arrange for the deposits and assets of the failed bank to be acquired by another bank. In this case, the failed bank essentially disappears, its customers becoming customers of the acquiror.

4 Michael Frachioni, Without a net in RMA Journal (Philadelphia, June 2004); see link.