Saturday, February 18, 2012

"The Doom Loop: Andrew Haldane Writes About Equity and the Banking System"

Mr. Haldane is Executive Director of Financial Stability at the Bank of England.
This is a subject we've touched on a few times. Here's 2009's "David Viniar, CFO of Goldman Sachs Blows Smoke at Journalists on AIG":
...My question is, "If Goldman Sachs were still a partnership, would they have entered into these transactions in the same size?"
The answer, of course, is no.
If partners equity were at risk, there is no way that they would have depended on ratings agencies to ascertain the strength of their counterparty.
Junior partners would be expected to run honey traps on AIG employees.
Lower level employees would hone their dumpster-diving skills.
Whatever it takes to gain competitive intelligence and safeguard the partnership's capital.
See also: "The optimal design of Ponzi schemes in finite economies"...

From the London Review of Books:
In 1989, the CEOs of the seven largest banks in the US earned an average of $2.8 million, almost a hundred times the annual income of the average US household. In the same year, the CEOs of the largest four UK banks earned £453,000, fifty times average UK household income. These are striking inequalities. Yet by 2007, at the height of the financial sector boom, CEO pay at the largest US banks had risen nearly tenfold to $26 million, more than five hundred times US household income, while among the UK’s largest banks it had risen by an almost identical factor to reach £4.3 million, 230 times UK household income in that year.
How do we make sense of these salary increases? Easily, in fact. During the go-go years, bank profits reached spectacular highs. Bank shareholders remunerated managers for delivering these riches; CEO pay grew almost exactly in line with shareholder returns. Reality then intervened. The heart-stopping global recession of the last few years was largely induced by financial sector excess. The long-term costs of the crisis are likely comfortably to exceed a year’s global income.

The continuing backlash against banking, as evidenced in popular protests on Wall Street and in the City of London, is a response not just to the fact that the world is poorer, as pre-crisis riches have turned to rags, but to the way these riches were privatised, while the rags are being socialised. This disparity is nothing new. Neither, in the main, is it anyone’s fault. For the most part the financial crisis was not the result of individual wickedness or folly. It is not a story of pantomime villains and village idiots. Instead the crisis reflected a failure of the entire system of financial sector governance.

In the first half of the 19th century, the business of banking was simple. The UK had around five hundred banks and seven hundred building societies. Most of the former operated as unlimited liability partnerships: the owners-cum-managers backed the banks’ losses with every last penny of their own personal wealth. The building societies operated as mutually owned co-operatives, with ownership, control and liability all pooled. Financial sector assets amounted to less than 50 per cent of annual UK GDP.

Banks’ balance sheets were heavily cushioned. Shareholder funds – so-called equity capital – protected depositors from loss and often accounted for as much as half of the balance sheet. Cash, and liquid securities such as government bonds, enabled banks to meet their payment obligations to depositors. They accounted for about a third of banks’ assets. Banking systems maintained broadly similar arrangements across the US and Europe. This relationship between governance and balance sheet was mutually compatible. Owing to unlimited liability, control was exercised by investors whose personal wealth was on the line – a potent incentive to be prudent with depositors’ money. Bank directors – the major shareholders responsible for day to day management – excluded investors who didn’t have sufficiently deep pockets to bear the risk. Shareholders were firmly on the hook, and had a strong incentive, in turn, to make sure that managers didn’t step out of line. Managers monitored shareholders and shareholders managers. In this way, the 19th-century banking model kept risk-taking in check.

The global environment was changing, however. During the first half of the 19th century, rich countries were hungry for capital to finance investment in infrastructure, including railways. As long as capital in banks was restricted to a small number of unlimited liability partners, credit was constricted. But in 1826, the six‑partner restriction on UK banks was lifted, allowing them to operate with an unlimited number of shareholders as joint-stock banks. Ownership and control became legally distinct – a crucial historical shift. Nevertheless, shareholder discipline was still proving an effective brake on risky lending and there was pressure for further liberalisation. One obvious solution was to limit shareholder liability so that their losses were no greater than their initial investment. Once investors’ personal wealth was no longer in jeopardy, bank credit would free up. In the UK, the change came with the Limited Liability Act and Joint Stock Companies Acts of 1855 and 1856....MORE