The period immediately after a major financial crisis, such as the Global Financial Crisis (GFC) that engulfed the industrialized economies between 2007 and 2011, is one ripe for radical financial reform. Cries of “this time is different” heard during the boom are replaced with shouts of “never again” as the bust unfolds.¹ Crises are the handmaidens of financial reform. For example, the requirement that a bank must publish an audited account of its assets and liabilities can be traced back to the collapse of Royal British Bank in 1856. The US Federal Reserve was created in 1913 as a direct response to the Panic of 1907. The 1929 stock market crash gave birth to the 1933 Glass-Steagall Act, which separated US commercial and investment banking for over 50 years. The 1974 establishment of the Basel Committee of G-10 Bank Supervisors followed the collapse of Germany’s Bankhaus Herstatt in June of that year and the ­subsequent liquidity crisis in New York. The list goes on.

The moment for radical reform is in the direct aftermath of a crisis. If this opportunity is not grasped, it soon gets submerged and bad reforms instead surge in. Oftentimes, regulators, caught up in extinguishing the fires of a financial crash, quickly recognize the point of origin. Despite having contributed to the crisis by designing the previous flawed bank regulations,² the Basel Committee of Bank Supervisors delivered a blueprint for meaningful reform as early as April 2009 (referred to as the revised Basel II or, more commonly, Basel III), a mere seven months after the Lehman Brothers collapse. Revised Basel II is for the most part a reasonable construct that attempts to address Basel II’s failures and push it in the right direction. But, over time, as taxpayers’ money has been seen to be bailing out wealthy, undertaxed bankers, and the ensuing government deficits has led to the scrapping of social programs for the less fortunate, justifiable moral indignation has morphed into understandable anger. This anger caused that early consensus on what went wrong to be lost amid the salacious details of individual villainy and created a backlash against government bailouts. Taxpayers were no longer prepared to be cast as the lender or insurer of last resort. The roar came for greater retribution and alternatives that were less state and taxpayer reliant. This chapter explores the extent to which such alternatives might work in the light of the actual problems that need solving.

Locking Up Bankers May Be Satisfying

Locking up bankers is not the solution to financial crashes. Since April 2009, many of the critical changes to the Basel Accord , such as the requirement for more stable funding and more equity, have been diluted and delayed. This retreat from Basel coincides with the strengthening of proposals seemingly focused on the punishment and shackling of bankers.

As discussed in the previous chapter, politicians are often drawn to the “bad apple” theory that crises are caused by bad people doing bad things often out of bad foreign jurisdictions. Having absolved themselves of responsibility as poor regulators they then embark on crushing all the bad apples they can pick. Both the Left and Right queue up to express their fury at the bankers in the eye of the storm. Even other bankers, not similarly tarred, joined the braying mob no doubt to emphasize their own innocence.

An illustration of these diverging trends occurred in September 2013 when Stefan Ingves, Basel Committee Chairman, told the Financial Times that the proposed capital rules on instruments could be softened. Yet, only a couple months earlier, the UK government had announced tough amendments to the Banking Reform Bill. These amendments, following on from the recommendations of the cross-party Commission on Banking Standards, consisting of distinguished members of both houses of Parliament,³ had introduced a new criminal offense of reckless misconduct for the management of a bank. The offense carries fines and a possible custodial sentence.

These legal initiatives, targeted at bankers, were framed by noble attempts to reduce the asymmetry of privatized gains and socialized losses. However, such initiatives will not protect us from financial crises. Moreover, because they increase the responsibility of senior managers on the one hand, and reduce their authority on the other, these measures could make banks even harder to manage—a scenario that bodes ill for financial stability. In Chapter 11, we will take a closer look at the role of criminal vs. civil law in financial regulation. For now it is suggested that while the palpable anger is justified, it solves little. The ascendence of the politically convenient idea that financial crises are caused by bad individuals condemns us to repeat boom and bust cycles.

Of course, individual bank failures may be caused by individual actions. However, the authorities are already well equipped to deal with individual bank failures. They did this well with the collapse of Bank of Credit and Commerce International in 1991⁴ and Barings in 1995. It is financial crashes causing destruction on a monumental scale that we must be better at avoiding, reducing, or cushioning. Huge financial crashes do not arise from random acts of malfeasance. As suggested in the previous chapter, busts almost always follow booms. The longer and wider the boom, the deeper and more all-encompassing the subsequent crash. Long, widespread booms do not happen because a few people do things they know are risky. Booms occur because droves of people are engaged in investments they believe are safe - so safe that it justifies doubling up on them. This misguided sense of well-being finds support in the dominant thinking of the day, broadcast by newspapers, universities, and even regulatory bodies. Often, the most sanctimonious regulators and central bankers are people who once presided over the annual publication of their central bank’s Financial Stability Review that was a cheerleader of the the idea that “this time is different” and that financial innovation will keep us safe as houses.⁵ The inconvenient truth is that even if all those potentially guilty bankers were not around before the financial crisis, it would still have happened.

There is a suspicion that when the UK Parliamentary Commission was considering amendments to the Banking Reform Bill and the introduction of a new criminal offense, uppermost in its members’ minds was the case of Mr. Fred Goodwin. As CEO of the Royal Bank of Scotland Group, Goodwin had led a meteoric expansion followed by a spectacular bust of the bank while receiving handsome personal rewards along the way. He had backed big leveraged buyouts and audacious takeovers that took this once-small regional bank to being ranked the largest bank in the world by assets.⁶ These takeovers include that of the larger National Westminster Bank, which RBS had incorporated when it was three times its size by assets; the expensive takeover of US-based Charter One Financial; and, finally, the ill-fated attempted takeover of ABN Amro. Overzealous expansion contributed to the timing and magnitude of a failure that was so enormous it demanded public involvement lest the entire financial system be jeopardized. If ever there was a case of reckless ­misconduct, this was it.⁷

Yet, for the better part of a decade, the supervisors of RBS did not find these buyouts and takeovers reckless. They cheered them on. Supervisors believed larger banks were safer for all because of their higher capital ratios and economies of scale. During Mr. Goodwin’s tenure, the RBS cost-to-income ratio markedly improved with profits, capital, and assets showing strong growth. Supervisors also had an implicit tendency of wanting “national champions” to grow large. It gave them a bigger seat at the table of international regulators. Finance, remember, was also routinely exempted from the remit of the ­competition authorities on the grounds of financial stability.

Further, banking often appears to benefit from economies-of-scale.⁸ Equity markets roared Mr. Goodwin on with higher share prices. The credit markets were unperturbed. His good deeds were even publically recognized when in 2004 the plain Mr. Fred Goodwin became Sir Fred Goodwin—knighted for services to the banking industry. The tragicomedy of financial crashes is that today’s criminals were yesterday’s heroes. What appears the morning after to have been a reckless party was deemed modern and clever the night before. In the fatal words of Chuck Prince, former Citibank CEO, “when the music is playing you have to get up and dance.”⁹

Bankers were allowed to place risky bets in which they pocketed the gains while passing on losses to taxpayers. What happens in the new regime to those who make reckless investment decisions but are lucky? There is a distinct danger that we end up criminalizing the unlucky ones, while letting the equally reckless but lucky, go free. Surely, the full range of fiscal and regulatory measures, coupled with civil remedies, must be used to alter this skewed incentive structure. Even if we could provide well-distributed justice, locking up individual bandits is not going to save us from financial crashes. It is this narrow thinking that fosters a dangerous complacency, which in turn makes us vulnerable to the next financial boom.¹⁰

We have shown that the criminal behavior of a few individuals is not the driver of crashes. Crises are the result of the madness of crowds. This runs counter to popular thinking that sees wisdom in crowds. Maybe crowds are often wise,¹¹ but we are not going to minimize the heavy financial, economic and social cost of crises if we do not address the collective delusions underpining 800 years of recorded financial folly.¹²

Any lasting solution must make us less beholden to malleable measurements of value and risk. The current measurements almost always underestimate risks in the boom and overestimate them in the bust. We must be less reliant on capital adequacy requirements based on these flawed measures of value and risk. Remember that many of the failed banks appeared well capitalized a year before crashing. In Chapters 5 and 6, we consider future rules geared toward minimizing the structural mismatch between risk taking and risk capacity—and do so across the entire financial sector. However, before looking at these proposals, it is useful to explore others that have gained popularity, especially in the United States, by promising to reduce tax payers burden through greater application of market discipline.

One of these ideas focuses on improving self-discipline by threatening bankers with jail time rather than reassuring them of a bailout. Attorney generals, who are political appointees, have been itching to stand up to the bankers and proclaim, “No bank is too big to jail on my watch”.¹³ This of course is easy to declare now but much harder to voice during a boom, when banks and bankers try to wrap up some of their profits in good works. We have just argued that there are challenges in relying on criminal law to protect the financial system and will consider this again in greater depth in Chapter 11.

Other popular bailout approaches to saving the financial system that don’t involve taxpayers include automatic bail-ins of creditors and limiting bank size so that they cannot grow too big to fail. A third idea is to ring fence the narrow retail parts of banks that the taxpayer would underwrite from the fancier parts of investment banking that they would not. What is common to all these proposals is the idea that competition and contained bank failure will provide the discipline to deliver a safer banking system without expensive taxpayer bailouts. In the rest of this chapter, we consider each of these ideas from the perspective of financial stability.

Why “Bail-Ins” Won’t Work

Bail-in securities, also known as hybrid bonds, “CoCos,” or “wipeout bonds,” are du jour in regulatory circles. A bail-in security is a bond that pays a coupon in good times. However, when the ratio of capital to risk-weighted assets falls below a preassigned level, the instrument converts into equity that is subordinated to all other debt and at risk of total loss. This new equity injection automatically dilutes existing shareholders. Regulators have approved instruments with an additional earlier trigger level that leads to the coupon being unpaid. The instruments could be market-based, contingent, convertible, capital instruments (so-called CoCos ). Alternatively, the bail-in may be part of an official resolution regime where bond creditors must be bailed in before there is any public capital injection, as in the case of the 2013 EU rescue package for Cyprus. A hybrid can also be used where the authorities treat certain instruments with preapproved automatic bail-in features as permissible forms of regulatory capital.¹⁴ Barclays, UBS, Credit Agricole, SNS Reaal, and Societé Generale have all issued hybrid bonds with projections that at least €150 billion (and maybe more) will be issued in the next few years.¹⁵

Bail-ins promise to rectify failing banks with minimal financial fallout and taxpayer exposure. This all seems quite proper. Recurring images of bankers placing large bets using other people’s money, running off with the winnings, and leaving the taxpayer to pick up the losses, have given this initiative political salience. But bail-ins are fools’ gold.¹⁶ They will not save taxpayers from exposure in times of financial crisis and could actually contribute to making matters worse.

While the terminology might be modern and clever bail-in securities are nothing new. They are market-based insurance instruments; a throwback to the failed philosophy at the heart of the Basel II Accord that made the market pricing of risks the frontline defense against financial crises.¹⁷ However, financial crises are a result of a market failure. Using market prices to protect against market failure simply will not work.

Financial crashes happen when markets least anticipate them. Bail-in investors underestimate risks in a boom and are shocked and ruined in a downturn. In 2014, even before the economy was fully free of the clutches of the Global Financial Crisis (GFC), investors were queuing up to buy CoCo bonds at levels of interest rates considered historically low but which looked good compared with near-zero interest rates available on short-term deposits or Treasury Bills. Credit Agricole’s CoCo, issued in February 2014 and offering a 7.8 percent coupon, generated $25 billion of orders chasing a $1.75 billion issue.

In stable times, bail-in investors will use the optimistic valuations of these instruments as collateral against other investments and expenditure. When an event occurs that brings prices crashing down, bail-in investors will lose substantially and simultaneously. As bail-in investors face gaping, unanticipated losses, everyone will leap into risk-aversion mode. The ensuing fire sale of assets will cripple financial markets, sending asset values into further decline and undermining the solvency of the banking system.¹⁸ One mechanism of this switch to general risk aversion, in a mirror image of the GFC, would be the likely contagion of rating downgrades of CoCos that would happen the minute one of them is unexpectedly converted into equity in the down phase of a macro-financial cycle . Bail-ins are supposed to happen before a bank has failed, to avert failure, but simultaneous bail-ins across a number of banks, coupled with the downgrade of CoCos issued by other banks, will bring a crisis forward and spread it. It is hard to imagine that anyone who lived through the contagious fires of a financial crisis would seek refuge in such an idea.

It does no good for protagonists of CoCos to argue that bail-ins were never designed to deal with systemic crises. If they are not created to meet this need, then they are unnecessarily dangerous. Central banks have already been dealing effectively with individual bank failures for decades. Furthermore, it is unrealistic to think that Europe only required another €150 billion of capital to offset bank losses and that bailing in this large but not overwhelming sum would not have been destabilizing. At the time of bail-ins being triggered, the markets would be paralyzed by uncertainty and spooked by a speculation of losses many times greater than the realized losses once the system has been stabilized. In September 2008, amid panic and a collapse in asset prices, creditors to Lehman Brothers were braced for a near $200 billion loss from its bankruptcy that month. However, by 2014, when the dust had settled and asset prices had recovered, the receivers were able to return them all of their money.

What’s more, there remains the vexing problem of who should be the owner of bail-in securities. In the interests of financial stability, it should not be other banks or investors who get their leverage from banks, like hedge funds. Banks would then have to make payouts when they were least able, increasing the likelihood of a liquidity-sapping fire sale of assets. Regulators are convinced that long-term investors should own bail-in securities. This is troubling. Saving taxpayers by pushing pensioners under the bus is objectionable. Moreover, bygones are bygones, and once we are in a crisis, the economic consequences of imparting a large current loss to pensioners—who tend to spend much of their pension income—is likely to be more severe than giving a liability to future taxpayers.

Furthermore, these securities are exactly the wrong kind of assets for long-term investors. Long-term investors, such as life insurers or pension funds, should hold assets where risks fall over time—like public and private equity, where being long term is an advantage. They should shy away from assets where risks rise over time, like bail-in bonds. If I own a bail-in security for one day, the probability of it ever being bailed in is much smaller than if I hold on to the same security for 25 years.¹⁹ Regulators ought to be alert to this.

Bail-in proposals make for good politics and bad economics.²⁰ Ostensibly, their raison d’être is to save taxpayers. Yet the experience of resolution-inspired “creditor bail-ins,” such as at Lehman’s in September 2008 and Cyprus in the spring of 2013,²¹ is that they end up being more costly than when taxpayers are more fully engaged through temporary ownership. This is borne out by the experience of Lloyds and RBS in the UK or AIG, where the US government recently realized a profit of $22.7 billion. The harsh truth is that once regulation has failed and a financial crisis is upon us, the only player with copious amounts of the assets that matter, good credit, and enough time, is the taxpayer. Crisis management that bypasses taxpayers will in all likelihood fail and would definitely be inefficient.

Perhaps systemic crises would be better understood if they were defined as a scale of crisis that cannot be privately self-insured. The amount of liquidity and capital required to insure a bank against a time when all liquidity freezes, and all asset valuations collapse, is not viable at a systemic or institutional level. Banks would become nothing more than deposit boxes, unable to provide significant credit and struggling to compete with that space underneath the mattress.

Why Eliminating “Too-Big-to-Fail” Is Not a Solution to Systemic Risk

A popular narrative of the financial crisis is that the banks knew that if they became really huge they would be classified as too big to fail.²² The story continues that the bankers knew that were their high-earning, high-risk bets fail, it would be reasonable to expect a bailout by the government of a large bank. Even in the near collapse and public rescue, they expected not to be sacked as they were the only ones with sufficient understanding of the complexities of a large bank to ensure any rescue plan succeeded. Managers might have to be motivated to help. They would not have to go into hiding.²³ The narrators of this story explain that this created at least two adverse incentives. Banks were encouraged to expand even when commercial logic, the capacity of internal systems, and the governance necessary to cope with size, dictated against such expansion.²⁴ Once banks became too big, they were further incentivized to take even riskier bets. The moral of this tale is to ensure that banks never get too big. In the words of Allan Meltzer, perhaps most famously quoted by Sir Mervyn King, “If a bank is too big to fail, it is too big.”²⁵

Like all popular narratives, this tale is simple and compelling. But it doesn’t sit well with the facts. It was actually the smaller banks, or at least those challenging the largest banks, that were the catalysts for the crisis. Think of Bear Stearns, Lehman Brothers, Countryside, and Washington Mutual in the US, IKB in Germany, the Cajas in Spain, Northern Rock, Halifax Bank of Scotland, and Bradford and Bingley in the UK. The crisis was based on these banks challenging the largest ones, like HSBC, J. P. Morgan, and Deutsche Bank, all of whom were better placed to withstand the eventual onslaught. This is typical of other crises too. One of the most severe banking crises in the UK, referred to as the Secondary Banking Crisis of 1973–75, occurred when the Bank of England had to avert the failure of 30 small banks and assist 30 others that had lent excessively to the bust property market—a common feature of banking crises. A decade later, the United States suffered the savings and loan disaster, where a quarter of the savings and loan associations in America failed. Taxpayers forked out $341 billion to save them.

It is certainly the case that a number of big banks quickly followed the smaller ones into crisis. Names like RBS in the UK, Fortis in Belgium, Allied Irish in Ireland, and Bankia in Spain are obvious examples of this phenomenon. Justification for their rescue has often been related to both their size and their interconnectivity. However, these were often small banks that had ballooned rapidly as a result of aggressive behavior and exhibited greater similarities to the “challenger” banks in their market-share hunger, than with the ­franchise-managing larger banks.

The evidence of financial crises disrupts simple conclusions. This includes the one suggesting that banking failures were driven by an irresponsible complacency borne out of the security of being too big to fail. Certainly, competition is almost always a good thing, especially from the perspective of customer choice and political independence. But the correlation between challenger banks, big or small, and subsequent bank failure, makes gray-haired regulators wary of concentrating on making banks smaller. The trade-off between aggressive competitors and financial instability is not an unfounded bias but rather one that is historically well supported.²⁶

Risk is caused by concentration. Increasing the number of banks might support financial stability if it increased total diversity in banking behavior. However, if the majority of banks behave homogenously then having more smaller banks will not impact diversity. They are likely to behave the same as a signal they are not a riskier proposition than others, or because they are compelled to do so to change by regulators or accountants on the grounds of “best practice”.

A mass of hungry, small banks may even increase concentration. Small banks, having a less commanding view of markets than the handful of large banks, tend to cling to the older, mechanistic, loan-approval systems. Being small and seemingly insignificant, these players disregard the significance of all banks lending to the same sector. Without a backward glance, they accelerate when in a booming economy, where borrowers look safe and their collateral appears sound. Four huge banks or forty smaller banks acting in an identical manner will produce the same outcome—a deadly increase in systemic risk. But rescuing, or taking into public ownership forty institutions is far more challenging than four. The savings-and-loan disaster and the secondary banking crisis were particularly frustrating, protracted affairs.

Policy makers may wish to make big banks smaller in an effort to increase competition and consumer choice. They may even be those courageous souls who want to see a reduction in the power of the bank lobbies by limiting the size of banks.²⁷ The lobbying power of an industry with many small players, for example savings institutions or individual consumers, is usually weaker than that of those industries with a few large players—such as banks, energy, and defense.²⁸

Increased competition and consumer choice and a weaker banking lobby are all laudable goals. But breaking up the big banks into smaller players with the expectation that this will lead to a safer financial system is misguided. If anything, it takes us into more dangerous territory. In a world where uncertainty is the only constant, the more players present, the more standardized the metrics employed. The larger the herd, the deeper the concentrations of risk—which indicates a higher probability of systemic failure and an even greater challenge in managing such failure.²⁹

A laudable alternative path is for regulators to insist that systemically important institutions carry additional capital. This would force banks to internalize the adverse, wider consequences of a bank being too big to fail while continuing to offer customers and well-capitalized institutions the benefits of economies of scale. Basel III and the Financial Stability Board have moved toward this alternative. Those classed as systemically important financial institutions (SIFIs) must set aside an extra dollop of capital, consisting of 2.5 percent of risk-weighted assets.³⁰

The utility of this approach would have to be prevented from erosion over time by the forces of political economy. There is significant reputational risk to regulators who fail to identify an institution that later proves systemic. Conversely, they face little reputational risk from identifying an institution as systemic even if it is not. Add the fact that there is no shared understanding of systemic risk, and it is likely that these lists will continuously lengthen and broaden in scope. The definition of systemically significant will get boiled down to size and it is likely that several large nonbank financial institutions will be netted by this definition. Many life insurers and asset managers have greater assets than some banks and increasingly find themselves classified as “systemically important” and treated as such. Yet, as long as their supervisors ensure that they stick to their core business, and their liabilities are not used as a cash proxy, or are not being on lent to others, then they are not systemic. Too broad a list would defeat the purpose behind requiring SIFIs to have more capital. The idea is to internalize the adverse social consequences of the private decision to become systemically important or not. Firms could choose to become systemically significant, or move into systemically significant businesses, but they would need more capital to do so. They may then conclude that it is more profitable to remain systemically insignificant. We will return to some of these issues in Chapter 5.

Ring Fencing

Another popular idea is to “ring fence” retail banking operations so they are insulated from perilous investment-banking undertakings. The argument is that taxpayers must bail out banks because were they not to act, the payments system would buckle and strain. No confidence in the payments system inevitably leads to the entire financial system failing hotly, followed by the collapse of the entire economy. The argument goes that banks endanger themselves by doing many things that are not related to the payments system. Some argue that if we could disentangle systemically important activities like deposit taking and loan making from the rest, we would be able to limit a taxpayer-funded bailout to the systemic, narrow, retail-focused division.

This would allow banks to do both investment and retail business, benefitting from common brands. However, these different activities would be ring fenced from each other. The ring fencing would be done to try and ensure that the failure of the investment bank would not bring down the retail bank, and, if the retail bank had to be rescued, it could be saved without aiding the investment arm of the operations.³¹ From a taxpayer’s perspective, the logic is impeccable. But it is not clear to me that this makes fundamental sense from the industry’s perspective. Are there strong benefits in creating common yet separate brands that would justify the existence of this odd creature? I suspect that investment bankers endorse ring fencing because they feel it will allow them to break free of the shackles of copious amounts of burdensome banking regulations that they feel are irrelevant to them.

Ring fencing is actually more troublesome than it first appears. Although there is much discussion around the growth of the shadow banking system and derivative instruments, this has been accompanied by a rapid expansion of bank lending. Shadow banking, derivatives, and the fancier side of banking, complement the traditional banking system. They are not the alternatives or substitutes some seem to believe they are.

After the collapse of Continental Illinois, as well as other individual bank failures, regulators became disillusioned with the traditional model where loan officers made subjective judgments on customers’ credit worthiness. The supposed independence of markets looked more attractive. Starting with the 1996 Markets Risk Amendment of Basel I and solidified with Basel II, regulators promoted the application of market values to traditional banking. Capital had to be set aside based on market valuations and the estimations of credit rating agencies. Before long banks were utilizing credit derivatives to measure, manage and allocate lending exposures. Removing these structures in order to ring fence simplified deposit taking and bank lending and makes retail finance more expensive but not necessarily any safer.

However perverse it may appear, the way forward to a safer financial system is to embrace risk rather than try to ban it. The oxygen of growth is risk. Risk must be managed, spread, pooled, and diversified. But to think we can make it disappear altogether is delusional. Any attempt to systematically rid one area of risk simply shifts it to a new location. As we rid it from that new area it simply shifts again. This process continues not until risk disappears but until we can no longer see it—hardly the makings of a good risk-management strategy.³² And yet this is the objective of too much of today’s regulation. To really tackle systematic risk we need to know as much about where it is going to as where it is coming from.

A better approach recognizes that in a growing economy there will be risk and the task is to decide how best to absorb it. This requires substantial risk transfers across the financial system. Large lending institutions, because of their potential for diversification across credit risks, have the capacity to absorb credit risk. They should be encouraged to hold credit risk. They should also sell the risk they cannot easily soak up. If they are typical banks taking in short-term deposits this is principally long-term liquidity and market risks. Long-term savings institutions with their long-term liabilities, have the capacity to absorb liquidity and market risk. They could buy these risks from banks and, in return, sell them credit risk.

Not all risk transfers are good. Those that took place pre-boom were the exact opposite of what would be desired from a systemic risk perspective and were at the center of the financial crisis. However this was largely because regulators made it costly for banks to take credit risks through capital requirements and discouraged long-term savers from buying illiquid assets. Consequently, risk ended up where it was best hidden from capital requirements and regulation rather than where it would have been best absorbed naturally. Banks were left carrying liquidity risk in vehicles that were off their balance sheets and had little risk-absorptive capacity. This shifted credit risk to hedge or pension funds. Of course these funds had even less natural capacity to hold the risks but the capital requirements for doing so were lower.

The right risk transfers happen when the capital adequacy regime reflects mismatches between an institution’s natural risk capacity and the risk it is holding. Risks are then incentivized to go where they are best absorbed and held. It is the simplest way to safely risk manage the financial sector while facilitating economic growth. In the next chapter, we shall look more closely at this concept and how it could be implemented. For now, I observe that poorly constructed ring fences hamper appropriate transfers of risk and create trapped reservoirs of badly matched credit and liquidity risks—a scenario that is neither safe nor efficient.

___________________

¹On January 20, 2010, President Obama introduced his proposals limiting the size and activities of the largest banks by saying, “Never again will the American taxpayer be held hostage by a bank that is too big to fail.”

²Avinash Persaud, “Banks Put Themselves at Risk in Basle”, Financial Times, October 16, 2002.

³See House of Lords and House of Commons, Changing Banking for Good: Report of the Parliamentary Commission on Banking Standards, www.parliament.uk/documents/banking-commission/Banking-final-report-volume-i.pdf, June 12, 2013.

⁴Regulators, in response to money laundering allegations, triggered the 1991 collapse of the BCCI. They did not step in to mop up a collapse that had otherwise occurred. BCCI remains a mystery. It was implicated in the Iran-Contra affair and the CIA-supported funding of the Mujahideen’s resistance to the Soviet invasion of Afghanistan. Regulators raided BCCI just as the Mujahideen declared victory.

⁵There are many examples and it is invidious to name names, but before history is airbrushed, it is helpful to reflect on the following quote from a highly intelligent central banker, no doubt consistent with the advice of his staff: “[It is] important [to ensure] that regulators keep enough distance from the markets to give financial innovations such as credit derivatives a chance to succeed. The new market for credit derivatives has grown largely outside of traditional regulatory oversight, and as I have described, evidence to date suggests that it has made an important contribution to financial stability.” Roger Ferguson Jr., Bank for International Settlements, Financial Engineering and Financial Stability, www.bis.org/review/r021122d.pdf, November 20, 2002.

⁶At its peak, RBS had assets of approximately $3 trillion and 200,000 employees.

⁷The case for the prosecution is best laid out in Ian Fraser’s book Shredded: Inside RBS, The Bank That Broke Britain (Edinburgh: Birlinn, 2014).

⁸However, the relationship between size and average costs has been found “to be U-shaped, suggesting that small banks can benefit from economies of scale as they grow bigger, but that large banks seem to suffer from diseconomies of scale and higher average costs due to factors like complexity as they increase in size.” Ingo Walter, “Economic Drivers of Structural Change in the Global Financial Services Industry,” Long Range Planning 42, nos. 5–6 (2009), pp. 588–613.

⁹The Financial Times quoted Mr. Prince in an interview on corporate buyouts done on July 9, 2007. Mr. Prince was still bullish even when it was clear enough that the music had stopped some time back.

¹⁰See Carlota Perez “Unleashing A Golden Age After Financial Collapse; Drawing Lessons From History,” in Environmental Innovations and Societal Transitions, vol. 6, March pp. 9–23, (2013).

¹¹See James Surowiecki, The Wisdom of Crowds: Why the Many Are Smarter than the Few and How Collective Wisdom Shapes Business, Economics, Societies and Nations (London: Abacus, 2006).

¹²See Carmen M. Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2011).

¹³At a press conference held on May 19, 2014 announcing the criminal plea by Credit Suisse in a tax evasion case, US Attorney General Eric Holder said that “this case shows that no financial institution, no matter its size or global reach, is above the law.” This seems to be the right stuff. However, I can’t help noticing that the firms the United States has targeted for megafines—UBS, HSBC, Standard Chartered, Credit Suisse, and BNP Paribas—are all non-US firms. This may be either a reflection of a nationalist motivation for justice or a concern stemming from the collapse of Arthur Andersen in 2002, when it was found guilty of criminal obstruction, showing that criminal convictions can collapse financial institutions. I can see, if not agree with, the political logic that says that if actions taken on the banks could kill them, better to kill the foreign ones that have modest local business.

¹⁴Under Basel III, CoCos could qualify as either additional tier-one or tier-two capital depending on the triggers.

¹⁵$150bn is an estimate attributed to Hank Calenti, Head of Bank Credit Research at SocGen, and quoted in “S&P Warns of Higher Risk in Bank Bail-in Bonds,” Financial Times, February 6, 2014.

¹⁶See Avinash Persaud, “Bail-Ins Are No Better than Fool’s Gold,” Financial Times, October 21, 2013, www.ft.com/intl/cms/s/0/686dfa94-27a7-11e3-8feb-00144feab7de.html#axzz3ADcuVPgd.

¹⁷Avinash Persaud, “Banks Put Themselves At Risk In Basle,” Financial Times, October 16, 2002.

¹⁸For a more detailed explanation, see, Avinash Persaud, “Why Bail-in Securities Are Fools’ Gold,” Policy Brief 14-23, Peterson Institute for International Economics, November 2014.

¹⁹This is a critical, though complex, point that we shall return to in greater depth in Chapter 5.

²⁰But it doesn’t make for good politics when a bail-in actually takes place—witness Greece, Cyprus, and Ireland—as those bailed in seldom feel they have been reasonably compensated for, or sufficiently warned of the loss.

²¹On March 25, 2013, the Eurogroup, (European Commission, European Central Bank and other EU agencies) and the International Monetary Fund announced a €10 billion injection of cash to Greece on the condition that Cyprus would bail in depositors. Deposits below €100,000 were saved in the final negotiations, but the accounts were frozen for deposits above this level as well as for other creditors. They were to be repaid based on the amount that the receivers could recover.

²²The logic was that because of the bank’s size, complexity, and interconnectedness, should it fail, there would be such severe, broad, and adverse consequences that the authorities would try to avoid failure by rescuing the bank.

²³Despite much heat and light about banks originating toxic instruments, when it came to rescuing the banks, many of the architects and traders of these instruments had to be retained, even lured by bonuses, so that regulators could understand, value, and unwind the offending instruments. The decision to retain them was not without anguish.

²⁴In my experience as a non-executive director of a few organizations, managements everywhere, not just in banking, assume that there are economies of scale and so growth will always improve the current financial position. Growth is then touted as the solution to financial vulnerability rather than a contributory cause. Instead, I have observed that organizations often exhibit unforeseen diseconomies of scale. After a period of growth, critical IT, HR, and accounting systems snap under the strain, requiring fast, unanticipated, and costly expenditures. This imperils the organization’s financial position, whereupon management touts the solution of more growth.

²⁵Allan H. Meltzer, “End Too-Big-to-Fail,” International Economy (2009), p. 49.

²⁶See: (1) Elena Carletti and Philipp Hartmann, “Competition and Financial Stability: What’s Special about Banking?,” in Monetary History, Exchange Rates and Financial Markets: Essays in Honour of Charles Goodhart, vol. 2, ed. Paul Mizen (Cheltenham, UK: Edward Elgar, 2003); and (2) Franklin Allen and Douglas Gale, “Competition and Financial Stability,” Journal of Money and Banking 36, no. 3 (June 2004).

²⁷See Mark Blyth, “The Political Power of Financial Ideas: Transparency, Risk, and Distribution in Global Finance,” in Monetary Orders: The Political Foundations of Twenty-First Century Money, ed. Jonathan Kirshner (New York: Cornell University Press, 2002).

²⁸This is not always the case. Some countries, especially those with a culture of local mutual-savings institutions, like Germany and previously the UK, convincingly argue that they speak with the powerful voice of “ordinary men and women.”

²⁹Avinash Persaud, “Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices,” Journal of Risk Finance 2, no. 1, pp. 59–65.

³⁰In November 2013, the Financial Stability Board (FSB) updated the list of globally and systemically important banks to include: Bank of America, Bank of China, Bank of New York Mellon, Barclays, BBVA, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Groupe BPCE, Group Crédit Agricole, HSBC, ING Bank, Industrial and Commercial Bank of China Limited, J. P. Morgan Chase, Mitsubishi UFJ FG, Mizuho FG, Morgan Stanley, Nordea, Royal Bank of Scotland, Santander, Société Générale, Standard Chartered, State Street, Sumitomo Mitsui FG, UBS, Unicredit Group, and Wells Fargo.

³¹This idea is perhaps best articulated and argued in the 2011 Vickers Report written by the Independent Commission on Banking. Set up by the UK government in 2010, the commission was charged with proposing structural reforms that would promote stability in the UK banking system.

³²See John Nugee and Avinash D. Persaud, “Redesigning Regulation of Pensions and Other Financial Products,” Oxford Review of Economic Policy 22, no. 1, pp. 66–77.