Gareth Morgan: Retail banking must get back to basics

Opinion

Saturday's election has occurred against the backdrop of global instability and the threat of a major meltdown.

That makes the prospects for our new government to deliver on its promises somewhat less certain than normal.

It's not their fault, it's just that the world is really struggling to deal with the consequences of 30 years of debt profligacy courtesy of the financial deregulation heralded in by the Thatcher/Reagan/Douglas era.

Three decades of sub-par central banking governance has seen an utter neglect of prudential policy and since 2008 it's been dawning on creditors that they've lent too much to those whose whole existence depends on their ability to raise ever more debt.

Meanwhile, the profits made by banks and their senior executives who organise these credit lines have been obscene and even after politicians have generously provided taxpayer funds to rescue the system, the profitability and bonuses of the bankers continue. It is one sick system.

Now that Europe, that bastion of monetary conservatism, is being rendered asunder as a consequence of the ravages of unfettered finance and the socialisation of bad lending (ie; issuing government debt to replace private debt that is "too big to fail"), we're witnessing some of the most bizarre political pressures and policy recommendations as politicians flounder to respond cogently.

Who would have thought that in Italy and Greece the politicians would have surrendered power to technocrats in the last-ditch attempt to stabilise their economies?

But the policy recommendations from the besieged politicians are getting more and more bizarre. For example, Angela Merkel and Nicolas Sarkozy are fans of a financial transactions tax apparently as a way of funding the cost of future financial crises. Desperation has descended on a political order bereft of solutions.

Taxes are either implemented to raise revenue or to correct undesirable behaviour. The financial transactions tax was conceived by Keynes (1936) and refined by Tobin (1972) to stop speculation, not to fund a kitty for state bailouts. It's never been implemented anyway, not the least because normal transactions would get clobbered as well and financial transactions would move to another jurisdiction.

If you accept that all speculators buy and sell financial instruments intending to make a profit and that such activity is vital to assure market prices reflect as much information as possible, then slowing this activity via tax is of dubious merit.

Certainly it would clearly raise the expense of conducting all financial transactions. Curiously the supporters of such a tax argue that where speculative flows are by far the greatest number of transactions, more of them would get hit and that somehow makes it okay.

Less speculation would ensue, but so would less trade. There has to be a more sensible response, even if every country in the world introduced such a tax - and that's what it would need to work - this approach would kill the patient.

Let's get back to basics. The ongoing global financial crisis has its beginnings in the "non-traditional" activities of the banks that have ventured into the murky world of shadow banking and off-balance sheet transactions. In short, they took bets on financial market prices, they supplied their balance sheets as collateral, stood as counterparties and even took primary positions themselves in forays to boost profits.

For a while they were wildly successful. Then they required a central bank and taxpayer rescue.

Even after the taxpayer bailout it's been a great ride for some, making their performance bonuses thanks to a taxpayer-provided boost to the balance sheet they can play with.

Should we be surprised about the Occupy Wall Street response? The events in Europe of late shed light on another series of banker-guzzle on the taxpayers' tab. And they can hardly be blamed for it as their windfall has arisen as a direct result of the nonsense that is the eurozone.

It seems perverse that within the single currency zone different countries can maintain different interest rate regimes, apparently to reflect differing risk on sovereign debt.

Yet under the Maastricht Treaty not just was one currency agreed on, but also that budget deficits would all be kept within 3 per cent of GDP - or the offenders would be fined - and an inevitable convergence of monetary and fiscal policy would result.

That would reduce divergence of economic conditions - and interest rates - across the region.

Well, as we know, that's been a joke. Deficits have burgeoned, and the size of risk differences between the member economies have widened, not converged. Ironically only Germany has seen its real wages fall in the face of the twin challenges of absorbing East Germany and confronting the rise of China. Accordingly, the sustainability of its economic growth has risen.

Elsewhere in the EU economic adjustment has been absent, wage rises have been given, labour practices become less rather than more flexible, and welfare benefits grown in unbridled fashion.

Such a diversity of economic management has facilitated plenty of opportunities for the financial arbitragers. For example, the nonsense wherein French banks could raise money from their own retail depositors and then invest that in Italy's government bonds, under a regime which implicitly, at least, guaranteed that no members would default on their sovereign debt.

Until now this has been a licence to print money via a handsome interest rate carry.

As we know Greece has defaulted, the French banks are up the creek, and the initial response of the eurozone governments was to guarantee those bondholders they'd get their money back. Now that guarantee no longer holds, the French taxpayer still has to bail out the once-were-massively-profitable French banks.

And what's more it's become increasingly obvious that these euro governments issuing great dollops of government bonds have no central bank behind them to be the buyer of last resort.

Oh dear, they're government bonds but not as we know them. And still Merkel says the ECB will not play that role.

The common theme through this whole post-2008 saga is that governments can't afford a run on the banks so they will underwrite the deposits no matter what the bankers do with them.

So long as the banks (owners and managers) can make enough money before it all turns to custard they're quids in.

That is the game - look for the quick buck and throw every bit of funding you can find at it, book the profits, claim the bonuses and then wait for it to all hit the wall. Once the bank is driven under, taxpayers recapitalise it to ride again so depositors are fine.

And so are managers and owners as long as they managed to make enough money while the music was playing. The taxpayer gets screwed.

We have a comprehensive breakdown of the banking system on our hands. Raising reserve ratios and improving the quality of capital required has been the response so far, but I'd suggest the sector faces an endemic moral hazard.

So long as it gets a government guarantee for depositors the government must in return dictate to the banks what they can and can't do. Otherwise you get what we all dream of - a taxpayer underwrite with no accountability required - yum.

The solution seems obvious. If a taxpayer guarantee is in place for depositors then the institutions taking in those monies should be severely restricted in what they can do - such as lend them according to old-fashioned prudential principles.

Since financial deregulation, the Bank of International Settlements and all its member central bank leaders have totally lost the plot on the practice of being prudent.

What should be beyond the scope of an institution that takes in deposits under a government guarantee is any ability to raise other monies that aren't taxpayer guaranteed, to issue bonds and subordinated debt and go and play in the shady world of derivatives.

The moronic "Quants" of the financial engineering world have blown up the financial markets by assuring their banker bosses they can quantify the risks. The bosses don't have to care, courtesy of the taxpayer guarantee.

A "back to basics" of retail banking is the place to start. If the central bank wants to control the risk to depositors in approved institutions it has to effectively control the risks that those banks take with those deposits.

This is a very simple principle that went out the window with the financial deregulation of the early 1980s.

Nationalising institutions that have a taxpayer guarantee is logical. At the very least a far more stringent, flexible and coherent prudential supervision from central banks is years overdue.

Gareth Morgan is a director of Gareth Morgan Investments.