After the fall

By Ian Fraser

Published: Sunday Herald

Date: October 5th, 2008

As the world braces itself for the consequences of the collapse of the financial system, a new model will have to be found to replace it. So where now for banking? By Ian Fraser

THE GLOBAL economy has now reached the tipping point. Last week was characterised by unprecedented stampedes of money across Europe, as central bankers and politicians strove to shore up their national banking systems with finger-in-the-dyke style measures at taxpayers’ expense.

Most counties are now prepared to launch some sort of lifeboat with which to rescue their busted banks. But each national government seems to be taking a different tack on how these vessels ought to be designed. This is partly the result of differing interpretations of the “moral hazard” involved in giving failed bankers an effective get-out-of-jail-free card.

With their talk of financial Armageddon, the bankers had convinced most of the governments in the developed world, including for a while that of the European Union, that whoever provides the most commodious vessel is going to win the economic war once the current market mayhem subsides.

Within the eurozone, however, there were problems. Howard Davies, a former chairman of the UK’s Financial Services Authority, said: “In the eurozone itself – which doesn’t include us – there’s a problem because the European Central Bank (ECB) provides liquidity to banks but the national governments are supposed to provide solvency.

“In other words if their banks are actually short of capital, it’s up to the individual countries to provide that. But clearly there is a link between the two.

“The ECB is nervous about providing endless amounts of liquidity if it suspects that some of these banks are not adequately capitalised. So in the eurozone there is an issue. We’re a little bit aside from that.” The issue is understood to be particularly pronounced for certain Spanish and Scandinavian banks which have been heavy users of the ECB’s generous liquidity scheme but have failed adequately to recapitalise.

The crisis was precipitated when US Treasury secretary Hank Paulson’s hastily cobbled-together $700 billon (£397bn) Troubled Asset Relief Programme (Tarp) was, perhaps unsurprisingly, voted down by Congress last Monday. A second version, a much more carefully constructed and sleeker model and with some important concessions to critics of the first document, was passed by Congress on Friday.

However, the Tarp is by no means a panacea. As Nouriel Roubini, professor of economics at NYU Stern School of Business puts it: “The claim by the Fed and Treasury that spending $700bn of public money is the best way to recapitalise banks has absolutely no factual basis or justification. This way of recapitalising financial institutions is a total rip-off that will mostly benefit – at the huge expense of the US taxpayer – the common and preferred shareholders and even unsecured creditors of the banks.”

Last week’s historic votes prompted some governments to up the ante by seeking to launch bigger and more expensive lifeboats before their rivals in other countries in the hope that their country would get recognised as the safest haven for investors’ cash.

This is what lay behind the Irish government’s controversial decision to launch a €420 billion lifeboat at the Irish taxpayer’s expense. The vessel is intended to be copper-bottomed, providing a blanket guarantee for savers. Irish bank shares surged for the third straight day in response to the government policy designed to strengthen deposits and reassure foreign financiers that it is safe to lend money to Irish banks. The Irish Stock Exchange closed 5% higher, bucking Thursday’s negative international mood.

Chancellor Alistair Darling and other European finance ministers were furious with the Irish as UK savers increasingly removed funds from accounts with UK-based banks and shifted them to Ireland. In the meantime, Scotland’s first minister Alex Salmond said that Scotland would have introduced a similar measure if the country had been independent.

As the talk and media coverage focused on the minutiae of cash flows, how to build a better lifeboat and short-term, Band Aid style solutions to the crisis, not many were thinking longer term.

Professor Joseph Stiglitz, the Nobel prize-winning economist, is one of the few to see the current crisis as an opportunity rather than a threat. The best-selling author of Globalization And Its Discontents and Making Globalization Work argued that the current extraordinary goings-on signal the death of the free-market fundamentalism that has dominated multinational organisations like the World Bank and International Monetary Fund as well as most developed world economies since the 1980s.

In an interview with the Huffington Post, Stiglitz said: “The globalisation agenda has until now been closely linked with the market fundamentalists – the ideology of free markets and financial liberalization.

“In this crisis, we see the most market-oriented institutions in the most market-oriented economy, the US, failing and running to the government for help. Everyone in the world will say now that this is the end of market fundamentalism.

“In this sense, the fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for communism – it tells us that this way of economic organisation has turned out to be unsustainable. We now know that the model doesn’t work. This moment is a marker that the claims of financial market liberalisation were bogus.”

So where now for the global financial markets? Roubini, one of the first to predict the current crisis, issued a stark warning. He said: “The risk of systemic meltdown is greater than ever.”

Irrespective of the nature of national bail-outs, Roubini predicts that we’re in for the mother of all bank runs this week. This, he says, will initially take the form of “a run on the $1 trillion-plus of the cross-border short-term interbank liabilities of the US banking and financial system, as foreign banks start to worry about the safety of their liquid exposures to US financial institutions.

“Such a silent, cross-border bank run has already started, as foreign banks are worried about the solvency of US banks and are starting to reduce their exposure.”

Given that we are unlikely to be returning to the debt-fuelled and probably corruption infested financial world that existed before the credit crunch, it is also worth pondering what sort of economic and financial worlds are going to be born out of the current crisis.

The multiple failures of banks in the developed world, largely caused by the greed and stupidity of many of those at the top – and by the culture where reckless lending was compounded by wholly inadequate corporate governance and controls, as well as a foolhardy dependence on short-term borrowing – are definitely going to cause a lot of economic and financial pain over the next few years.

There will almost certainly be a global recession. Graham Turner, of GFC Economics, said: “I believe we are now sliding into a global recession. There is only one country capable of withstanding that; China, where interest rates were cut this week.”

House prices in the UK can be expected to continue to fall until well into 2010, and in some parts of the country they could tumble by as much as 50% from the crazy levels seen in spring/summer 2007.

In Scotland, the pretence that you can build an economy on having a vibrant financial services sector has been shown to be unviable. Financial services is the sector where the most jobs are going to be lost in the next few years. If Lloyds TSB and HBOS do consummate their anti-competitive merger and create a UK “superbank” then 7,000 jobs could go in Scotland and 40,000 across the UK.

A lot of things will change as a result of the current round of bank failures and state bail-outs. The game is up for the post-Big Bang City fat cats – who in a “light touch” regulatory climate have got away with underhand behaviour including insider dealing for many years.

In banking, the sales-driven culture that polluted British and some other European countries since the 1970s will also cease, something which ought to come as a relief to many customers.

While it is unlikely that we are going to see a return of the era of the Captain Mainwaring-style bank manager, the culture of spivvery, and high-pressure sales that has permeated most British banks will also certainly become a thing of the past.

In its place we are going to see a banking system that looks much more like the “utility” model which Britain had in the 1950s and 1960s. It will be a low-risk banking system, and one where the profits are going to be much lower than they were in the 1990s and the Noughties. Credit rating agency Standard & Poor’s says that “the survivors are going to be those banks that have learned and applied the lessons to live with new realities, not those which hanker for a past that no longer exists”.

Financial regulation is also going to be tightened up, as banks cannot be granted a liberal safety net by the taxpayer and expect to go back to the loosely regulated free-for-all that existed before. Ian Blackford, former managing director of Deutsche Bank and head of its Dutch equity business says: “Our political leaders now have a responsibility to put in place regulation that prevents this crisis ever happening again.

“There needs to be a far-reaching debate on how regulation should work and at what level. These are global problems and they require global solutions. Capital, after all, is mobile.”

At a dinner in Edinburgh last Thursday Michael Howard, the former leader of the Conservative Party said that Britain needs to return bank supervision to the Bank of England, where it was housed prior to 1997.

In the long term, these sorts of changes are going to be hugely beneficial to both business and society. It will mean that rather than the abuse of customer relationships that has destroyed people’s trust in their banks, the banks should once again recognise that their main role is to serve their customers and safeguard deposits rather see banking as a means of enriching themselves and their shareholders.

One London commuter said: “Outside the City bubble, many people are shocked to find that bankers, once serious folk you’d doff your cap to for a loan, are in fact bonus-fuelled casino operators. What a mess.”

This article was the business focus in the Sunday Herald on October 5th, 2008

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