Efforts to change behaviour of bankers is laughable

The US and UK are afraid to clamp down on large banks in case they decide to locate themselves offshore

IF YOU have not been concentrating for the past few months, you may think that nothing much has changed in the world of finance. Banks such as JPMorgan Chase and Goldman Sachs have reported large profits for the second quarter, helped by big fixed income trading revenues, having repaid the equity injections the US government made in them last autumn.

Meanwhile, regulators struggle to devise a solution to the glaring problem that, as we now know, such institutions are too big to fail. Not only do they enjoy day-to-day access to central bank funding, but they are bound to be bailed out if trouble strikes; there is no use denying it.

The latest attempt to rewrite regulations to address this came from Britain’s Conservative Party this week. The “big idea” of George Osborne, the shadow chancellor, is to abolish the Financial Services Authority and hand over the prudential supervision of all financial institutions to the Bank of England.

The bank is doing better politically than the US Federal Reserve, which faces hostility from Congress after the US Treasury proposed beefing up its powers. Thus, most political energy is now being expended not on regulation itself, but on the name of the regulator. Given the scale of the crisis we have just endured, and appear to have survived, this is pathetic. If I were a banker, I would be laughing discreetly at the bumbling and misdirected efforts of governments to change my behaviour. This may be overly cynical, but I suspect Osborne of coming up with his grand reshuffling of regulatory institutions to divert attention from the fact that he backed down on a genuine structural reform – the separation of retail banking from investment banking by creating a British version of the 1933 Glass-Steagall Act.

His explanation for floating the idea and then dropping it in the Tory “white paper” on financial regulatory reform was that “while there are some value arguments for this approach if implemented at an international level, it would not be feasible or desirable for the UK to impose an absolute separation unilaterally”.

This leaves us precisely where we started, with France and Germany tilting misguidedly at hedge funds while the UK and the US fear clamping down on large banks in case they move from New York to London (or vice versa), or locate themselves offshore.

Osborne is right that it would be best to have a co-ordinated approach to banking laws to prevent regulatory arbitrage, but given that the UK could end up, according to the International Monetary Fund, spending 9 per cent of its gross domestic product on supporting the banking sector, it cannot afford to hang out for that. I have argued here before for some form of Glass-Steagall separation and, if this cannot be done by fiat because the detail is too difficult, then it ought to be engineered through financial incentives.

At the moment, these incentives work in the opposite direction and have become more pronounced. Large banks were allowed to hold less capital under Basel II rules because they were not only considered cleverer but supposedly had the risk reduction benefits of portfolio diversification.

Now, big investment banks not only have economies of scale on their side and an implicit government guarantee that lowers their cost of funding, but are also treated for regulatory capital purposes similarly to smaller and less systemically important banks.

Of course they will carry on ramping up trading and paying their employees handsomely. As Mervyn King, the Bank of England governor, said in a recent speech: “It is not easy to persuade people, especially those who are earning vast sums as a result, that what looks successful in the short run is actually highly risky in the long run.”

King also called for regulation to be simple and robust. In that spirit, a good way to make some of the incentives less perverse is to impose a much bigger regulatory “tax” on big banks than small ones, through higher capital charges and tougher limits on leverage.

Similarly, initiatives such as the FSA’s crackdown on long-term guaranteed bonuses for star investment bankers ought to apply to large institutions rather than small ones. If a hedge fund that can be allowed to disappear in future overpays its traders, who cares?

For now, the likes of Citigroup and American International Group need to pay enough talented people to get them out of trouble and refund taxpayers. But in the long term, it would be a good thing if they could not compete on pay with small private equity and hedge funds. The UK Treasury made some half-baked arguments this month about why small institutions can be just as risky as large ones to the system. But our intuition is true: it is necessary to have strict limits on banks deemed “too big to fail”.

Before this crisis, central bankers were wary of acknowledging that any bank was in that category, but there is no point in maintaining that pretence now. Such institutions exist, call them too big to fail, systemically important, Tier 1 financial holding companies, or whatever.

In fairness to Osborne, he is one of those who favours treating large banks and small ones differently. But, like other politicians, he has moved swiftly on to a distracting argument about institutions, instead of keeping focused on the incentives that might actually make a difference.