Key financial firms won't be allowed to fail again: expert

Charles Goodhart says a range of opinion exists globally on how best to overhaul financial regulation for the future. Photo / Mark Mitchell

Such was the fallout from the collapse of Lehman Brothers that a legacy of the financial crisis is that authorities will not allow systemically important financial institutions to close their doors, says Professor Charles Goodhart.

Concerns about moral hazard counted for less and less as the crisis spread. "Post Lehmans, no central bank is likely to allow any systemically important institution to shut," he said.

Preserving financial stability has come to mean maintaining not just the liquidity of the system but the solvency of institutions which are too big to fail.

As the well of taxpayers' money is not bottomless, that makes it all the more important that financial regulation is overhauled so as to minimise the risk of repeating the crisis and the associated bailouts.

But as Goodhart said in a lecture in Wellington, there is no clear consensus yet on how that should be done.

Europeans favour a regulatory approach, centred on a counter-cyclical requirement for banks to build up extra capital when times are good, both to moderate the cycle and to ensure they have more resources when it turns down and the pressure comes on.

Americans, with a general preference for markets over regulation, favour a system that would require banks to take out some form of financial health insurance.

With the countercyclical capital approach the question is whether it can be reduced to a rule, mechanically applied, or should be left to the discretion of the central bankers.

Central bankers argue a rule would be too rigid and prefer reliance on their judgment, Goodhart said. But academic economists argue that the need to tighten capital requirements would arise just when everything is looking good.

Borrowers, lenders and politicians would all be opposed and it would take exceptionally courageous central bankers to stand against that.

Goodhart's own position is a compromise between the central banker and academic views (perhaps reflecting a distinguished career in both callings).

He favours a "comply or explain" model where there is a rule and the authorities have the choice of enforcing it or explaining why not, knowing that the decision will have to bear the scrutiny of hindsight.

That, Goodhart suggests, would stiffen their resolve.

Fortitude would also be required in unwinding the capital charge.

The idea is that it would only be in place for limited periods, perhaps one year in five, and would not raise the cost of capital over the whole cycle.

But its critics say that when things go bad and it is appropriate to remove the charge is precisely when the markets are risk-averse and want to see banks holding more capital. They predict a ratchet effect - not a countercyclical capital requirement just a higher one, full-stop.

The American, insurance approach presents even greater problems, Goodhart concludes.

President Barack Obama's announcement two weeks ago of a levy on the big banks, the "financial crisis responsibility fee", to recover over 10 years or so the cost of the Tarp bailout, could be seen as a kind of insurance premium. But it is imposed after the event on those who survived it.

And it is levied on the banks' wholesale debt funding only, not their equity or their deposit base. That reflects a more general trend among regulators to be concerned about banks' reliance on short-term wholesale funding.

But compelling them to become more reliant on retail funding is likely to constrain credit growth and retard the recovery, Goodhart argues, and would be especially hard on small and medium enterprises which cannot access capital markets directly.

Another option under consideration is the "coco" or contingent convertible debt, which turns into bank equity when a trigger is pulled.

Who would want responsibility for pulling that trigger? And this form of debt would convert to equity at precisely the time nobody wanted bank equity, making it deeply unattractive to the likes of fund managers.

While regulators wrestle with these issues they have more time on their side than is commonly supposed, Goodhart says.

While others contend there is a narrow window of opportunity to set financial regulation to rights before memories of the crisis fade, Goodhart sees a greater danger in ill-judged regulation drawn up in a context of popular anger.

"For the next five years the regulators could all go home. The banks will behave themselves," he said. "When you really need regulation is just when the private sector believes it isn't necessary."

CHARLES GOODHART
* British economist.
* Professor at the London School of Economics.
* Aged 73.
* Former member of the Bank of England's Monetary Policy Committee.
* Developed Goodhart's Law in 1975, which states: "Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes."