Who's killing capitalism?

Stephen Bartholomeusz is one our more sophisticated commentators. Late yesterday he took a turn around the G20 and Basel III actions on banks and it is useful to walk with him and ask a few sticky questions:

The G20 meeting that starts in Seoul tomorrow is expected to finally launch the tough new Basel III prudential regime for banks. There are, however, signs that the consensus among regulators about what the regime should look like is not as strong as it has appeared.

The Swiss have already pre-empted the introduction of the new regime, which involves significantly higher capital and liquidity requirements, by imposing far tougher requirements on their two systemically important banks, UBS and Credit Suisse, than is envisaged under Basel III.

That has sparked fears that there could be a "race to the top" as individual regulators and institutions scramble to occupy the top tier in the new prudential rankings.

That could leave weaker systems and institutions behind and vulnerable and could fracture the concept of a new globally harmonised set of rules that would be carefully phased in over an eight-year period to avoid the potential economic fallout from a global rush to far more conservative balance sheet settings.

That doesn't sound so scary to this blogger. In fact, it sounds down right reassuring. That's precisely what all regulators, everywhere should be aiming to do. Ironically, the Gillard government is one those fighting the outcome. Clamping down on speculation of all sorts may slow banking but if it avoids another crisis then it's likely to be a path to higher and more sustainable growth in the long run. Back to the article:

Overnight the Financial Times reported another threat to that plan for a set of globally consistent rules for banks, saying that politicians and regulators had now concluded it was too complex a challenge and that the new regime should be focused on banks with global businesses. Banks with largely domestic exposures would be regulated as their domestic regulator saw fit.

A two-tiered system of prudential regulation is superficially appealing. Impose capital and liquidity surcharges on the biggest and most complex of banks, operating in multiple jurisdictions, whose failure would create global financial shocks and leave the rest, however important within their own domestic system, to the local regulators.

That would, however, mean that the international banks could be – almost certainly would be – at a very significant competitive disadvantage to their domestically-focused and regulated rivals. It would create incentives for the international banks to retreat to their domestic economies. (Given that they already face heavier capital burdens, perhaps that should be "even greater" incentives).

That would raise the prospect that the globalisation of the banking and financial system that has occurred over the past three or four decades could be significantly unwound – or that the conduits for global financial flows would move even further outside the regulated banking systems. That’s not necessarily desirable.

Global banks are the conduits of global speculation through lending, proprietory gambling and issuance of derivatives. The latest BIS report into OTC derivatives says that the daily global turnover of currency and interest rates instruments is $6.1 trillion. Global GDP is roughly $60 trillion. So every ten trading days global markets, through global banks, turnover the equivalent of GDP. Don't even try to tell me that's not radically destabilising. If fact, it's circular. The bigger and more unstable it gets, the more everyone needs it to hedge. Go figure. Back to the article:

It has been an unfortunate side-effect of the financial crisis that politicians, regulators and communities have become more insular.

In those economies – the US, UK and Europe – where taxpayers have had to foot enormous bills for bailing out reckless institutions, there is a understandable angst about the notion of their taxpayers underwriting risks taken by banks outside their home economies.

Even in this system and economy, which was barely touched by the crisis, Joe Hockey and others have raised that same question in relation to ANZ Bank’s pursuit of its Asian strategy. (Curiously, there hasn’t been the same level of concern about the large exposures of all the Australian banks in New Zealand, or even of NAB’s big UK and small US presence).

Pre-crisis, Australian companies and institutions were being criticised for not building better positions in Asian economies and taking advantage of our proximity to the fastest-growing economic region of the globe. Now banks’ engagement with other economies is being discussed in the context of the risk to taxpayers.

Banks that demonstrated that they have been prudently managed and regulated are now being savaged because they have followed, or soon will follow, the Reserve Bank’s signal that it wants higher lending rates. (The RBA would have been well aware when it lifted official rates on Cup Day that most of the majors were near-certain to add their own premium to the 25 basis point increase).

This blogger disagrees with this characterisation of the Australian banks. They are enthusiastic participants in the unstable global financial system that Bartho is ambivalent about. The Australian system carries roughly $14 trillion in off balance sheet derivatives that, in part, are directed toward managing the interest rate and currency risk associated with their offshore borrowings. Although they have managed these risks ok, they have completely ignored an enormous liquidity risk that has built up as the borrowings mushroomed. Liability management is an integral part of banking. It's failure leads to bailouts, like the wholesale funding guarantee. Back to the article:

Populist politicians will take advantage of their communities’ lack of understanding of the drivers of bank profitability and of how painful and traumatic it is (as we experienced in the early 1990s) to have unprofitable banks – and of fading memories of what the sclerotic pre-deregulation system was like.

Given the simplistic and highly politicised nature of the debate, here and elsewhere, it isn’t surprising that the benefits of globalisation of trade and capital flows, particularly for developing economies – or those, like Australia’s, directly exposed to them – generally aren’t being factored into the discussion.

Hang on a minute. Why are trade and capital flows coupled here? It is entirely possible, indeed eminently sensible, to believe in free trade and regulated capital flows. In fact, to preclude the possibility risks being simplistic and highly ideological. To think of regulating one because it is nothing more than a casino does not automatically imply regulation to the other. The BIS 2007 Triennial reckoned that only 17% of the then $5.3 trillion in OTC daily turnover made reference to real commerce and government transfers. If anything policy-makers aren't doing enough. A Tobin tax or the like is needed to rein this in and prevent another gambling-driven calamity that wallops real commerce.

A comprehensive and globally harmonised set of much tougher rules for capital adequacy and liquidity won’t guarantee that a big bank won’t fail. Industry levy arrangements (like the one in place for Australian bank deposits) or even formal deposit insurance schemes won’t guarantee that taxpayers might not be asked to help bail out a systemically important institution in the future.

They will, however, reduce the risk and cost of a failure and those risks and costs need to be assessed against the risks and costs associated with winding back or disrupting decades of globalisation of trade and financial flows by handicapping the institutions that represent the most transparent and regulated conduits for those flows.

The regulators and their political masters do need to create a safer global banking system. They also, however, need to be mindful that there is a broader context in which banks operate and that in making banks safer they don’t significantly diminish their ability to contribute to both domestic and global economic development.

You bet there is a broader context. And it is that free markets need a new contract with liberal democracies that doesn't encourage historically outrageous gambling. That is what is wrecking capitalism and sooner or later it is going to kill it if it's not regulated first.

For those interested in more on the proposal to regulate the global banks try Yves Smith.