Hosting a party is not easy. Provide drink, sure, but if the guests start getting too drunk, take it away quick. It’s a delicate balancing act: provide the lubrication required to get the party moving, remove it before it gets out of hand.
It’s a bit like being a central banker. As Mervyn King said yesterday, “It is often said that the role of a central bank is to take the punch bowl away just as the party is getting going.”
But, returning to the party of revellers, what happens if you remove the drink, only to discover the guests have brought along their own Party 7s, Babycham and warm Lambrusco?
Well, it is like that at the moment, only the drink supplied is more akin to Dom Perignon. Yesterday, Mervyn King told the British Banking Association that all those efforts by the central bank to quieten things down will come to naught if the opposite applies to the financial sector. “If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder.”
“That might not matter were the consequences limited to the party-goers. But they are not. When the party ends, some innocent bystanders may lose their homes altogether. Moreover, the party-goers aren’t just deposit-taking banks. A wide range of financial institutions, including investment banks, monoline insurers, even hedge funds, have the potential to cause significant damage to the rest of the economy in the wake of their demise. Are they all to be helped to get home safely when the party ends? If so, will they all be regulated in the same way as banks? If not, how can we limit the potential cost to the taxpayer? Add to this the problem that many of these institutions are global in scope, but the responsibility for both regulation and rescue remains firmly at national level, and you can see why policy-makers get headaches as bad as the party-goers.”
Earlier in the speech he touched on moral hazard. “Banks should be allowed to ‘fail’ so as to preserve market discipline on financial institutions,” he said.
But in his conclusion he talked about the. “… intractable problem of how to change the incentives of both private and public actors to reduce the frequency and cost of financial crises. For that we will all need to do a lot more thinking. It is important that we do find the right solution. An efficient and thriving banking sector which can intermediate saving and investment, both domestically and internationally, is essential to our economic prosperity.”
And in his speech he really summed up the specifics of what will become a hotly debated topic over the next few years.
The danger has to be that both banks and policy-makers act in sync. Banks become more cautious – perhaps too cautious, at the same time new regulations create a tightrope around their necks. So the danger then becomes too much regulation.
In the wake of the Enron and WorldCom collapse the Sarbanes Oxley Act was passed in the US to try and ensure no repeat of those disasters. But the Act itself was a disaster for the US financial sector, such that when former London Mayor Ken Livingstone was in New York a few years ago, and was asked why London was doing so well, he said, “Two words: Sarbanes Oxley.”
Banks must learn their lesson, it is true, but the time to put that lesson into practice is during the height of the next boom, which won’t be for quite a few years.
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