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John Quiggin

Let banks be banks again

John Quiggin Australian Financial Review

4 December 2008

Over the past few months, the global financial system has seen changes that would have seemed inconceivable if they had not actually happened. Trillion dollar bailouts, large-scale nationalisations and the seemingly permanent closure of markets with trade volumes in the hundreds of billions have flashed past so rapidly that the changes have been just about impossible to absorb.

Not surprisingly, the response of most participants in the system, including regulators, governments and financial corporations has been to treat these changes as emergency measures, and to aim at returning to normal conditions as soon as possible. This has been particularly evident in Australia, where the direct impact of financial crisis has remained relatively limited.

In particular, having opposed deposit guarantees up to the last minute the big domestic banks are lobbying to ensure that they are removed as soon as possible. Yet there are good reasons to doubt that this will happen.

There was a suggestion at the time the guarantee was introduced that it was an over-reaction to moves elsewhere. In fact, however, Australia’s action was copied throughout our region.

More importantly, the US increased its guarantee from $100 000 to $250 000 and the EU has agreed on a uniform minimum guarantee of 50 000 euros, rising to 100 000 euros in 2009.

In a world where explicit guarantees are virtually universal, and where chaotic economic conditions are likely to continue for years, it will be a brave government that is the first to do away with them.

The broader point here is that the ‘normal’ conditions of the past decade or more are, in all probability, gone for good. By the time the global recession is over, the deregulated system of global finance built up since the 1970s will be completely broken, with its major institutions either gone altogether or dependent on national governments for their survival.

The problem for policymakers will not be to recreate this failed system, but to design a new one, without the extreme vulnerabilities that produced the current crisis.

The global rush to bank guarantees may represent, in retrospect, the first step in this direction. In place of a shadowy system of implicit guarantees, governments are starting to draw clear lines of demarcation. The most important is that between banks and their deposits, which have a clear-cut guarantee, and non-bank financial institutions, whose investors are expected to accept the risk of failure. Not surprisingly, institutions in the latter category are rushing to become banks as far as possible.

The next problem to be tackled is that banks, both old and new, invariably want to have it both ways. They want the security that goes with (implicit or explicit) government backing but they don’t want to miss out on opportunities for profitable investment, even where these increase risk. Examples of these practices abound.

Regulated banks have set up or acquired unregulated subsidiaries, then called for rescue when the subsidiaries have run into trouble. Banks have marketed a wide range of financial assets, with varying degrees of depositor protection, through the same branches that accept guaranteed deposits. The effect is to blur the meaning of the government’s guarantee. Worst of all, banks have used their ‘too big to fail’ status to become investors on their own account, turning business risks into systemic risks. The result, evident in recent months, is the classic combination of capitalised profits and socialised losses.

Attempts to address these problems through regulations such as the Basel I and II capital adequacy requirements have failed completely at a global level. Although Australia’s regulatory system has held up fairly well so far, there are large losses still to come, and serious vulnerabilities from our dependence on overseas finance.

The most plausible solution is a system of ‘narrow banking’ where regulated and guaranteed banks are confined to a specific set of low risk activities with well-established accounting rules. Financial innovation in this sector should be tightly restricted to ensure that new financial assets do not produce the kind of risk transfer to the public seen in the current crisis.

The narrow bank sector should be strictly separated from other financial markets, such as equity markets, and governments should make a clear commitment that non-bank financial institutions will never be allowed to become ‘too big to fail’, or rescued if they run into difficulties.

No one can say when the current global recession, already a year old, will end. But it is time to start planning how we can avoid a repetition.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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