Fixing the financial sector


Earlier this week I went on Radio Five to talk about Lord Turner’s suggestion that the directors of failed banks should face having two years salary clawed back by the financial regulators (available here at 1:49:00). Surprisingly enough, I didn’t think much of the idea.

It is true that Lord Turner is identifying a real and serious problem: bank directors are sometimes insulated from the consequences of their business decisions, and have an incentive to take on more risk as a result.

But as well as being ethically dubious – the burden of proof would rest with bank directors, who would be forced to justify perfectly legal activities or face arbitrary punishment – Lord Turner’s proposal is a distraction from the real problems in the banking sector. Politicians and the media enjoy obsessing about executive compensation, but in the real world it is a very marginal issue.

The real problem is threefold:

  • Firstly, we all know that governments won’t let banks fail. Shareholders and bondholders know they aren’t going to lose money, so the market supervision of banks is weak.
  • Secondly, deposits are guaranteed by the government, which means people pay almost no attention to what the banks are doing with their money.
  • Thirdly, commercial banks can always borrow money from the Bank of England to paper over liquidity problems – this encourages them to spread themselves thin.

The result of these government interventions is that the banking sector is hard-wired for risk in a very fundamental way. In this context, after-the-event clawback of directors’ salaries will make virtually no difference – aside from feeding anti-banker, class war sentiment.

On that point, I was quite astonished to be asked why I objected to Lord Turner’s proposals, given that bankers earn loads of money, and rules like these would make poorer people ‘feel better’. The point of financial regulation isn’t to make people feel better about themselves – it is to ensure that we have a stable financial system. That’s the only basis on which Lord Turner’s proposal should be judged.

What would a better approach look like? Well, we need a proper bank resolution scheme that avoids bailouts and makes sure bondholders and shareholders lose out – compulsory debt-for-equity swaps may be a sensible idea. We need the Bank of England to be much stricter on lending money to banks, perhaps even going so far as to close the discount window. It needs to be made clear that it is up to the banks themselves to stay liquid and solvent. And we need to get rid of deposit insurance, perhaps requiring banks to offer a 100 percent reserved ‘safe haven’ account while publishing reserve ratios for other accounts, so that depositors demand an appropriate degree of conservatism. 

For more on free market approach to financial reform, see Professor Anthony Evans’ 2 days, 2 weeks, 2 months: A proposal for sound money. On the deposit insurance point, see the Carswell-Baker Bill.