Taking on the banks

I have on earlier occasions been ranting about the way the US Administration missed an opportunity to reset the clock on the balance between government and the financial sector. No doubt, I am a great fan of the consequential and straightforward way the Swedish authorities handled the financial crisis in that country in the early '90s. To date, I have still not seen anything that would convince me that the same model could not have been applied in the US.

All of that is now history, and we should look forward to see how the issue of "too big to fail" (TBTF) is being handled. It is widely accepted that large institutions had scant regards for risk, simply because the gambled on being sufficiently big that the US Government would bail them out in case of trouble. Many observers believe this "Moral Hazard" to be the ultimate reason for the banking crisis.

For this reason it is interesting to see how the two governments deepest influenced by the financial crisis, the US and UK governments are handling the situation. There have been no shortage of observers pointing out that even if the financial institutions were TBTF but certainly not "too big to be carved up". The idea is that by splitting up the banks, one would reduce the risk of a systemic breakdown.

Over the weekend, news came out from the UK that the government would use its status as large shareholder to force a carving up of some of the largest banking groups in the UK, namely RBS and Lloyds TSB. It appears that carve-outs from these two banks together with the branches of Northern Rock, will be turned into three new retail banks. Several other business activities will also be sold off.

All in all, the government intends to recover some of the billions poured into the banks by divesting business activities. They will increase competition by bringing in new investors to the UK market (read: decrease the power of large banks in the UK). Further, the intention is to let RBS and Lloyds TSB "pay" for the participation in various elements of guarantee or insurance schemes. This latter element is a smokescreen as the "fees" will come out of dividends that would otherwise have gone to the biggest shareholder – namely the government. General elections are obviously coming up....

The US will likely choose a different way. For one, the Administration is favouring a shake-up of the regulatory bodies and it may end up creating a Financial Stability Council to monitor systemic risk in the economy and identify specific problem areas for attention.

Secondly, the approach to reducing the systemic risk of having a large number of TBTF institutions is aimed at using the market logic. So far it appears that the Administration will have discretionary powers to define institutions of systemic importance. These institutions will have to work with higher reserve requirements. An institution thus defined to be of systemic importance will have serious problems delivering the return on equity obtained by other institutions not defined to be of systemic importance.

Shareholders and management of central financial institutions would then have strong economic incentives to avoid being classified as "important". Trying to regulate by managing the market forces appears attractive to an American culture of leaving the markets to work their magic, but as always the details are important. And that is what remains to be seen. Will this seemingly clever idea make it through Congress intact under the predictable onslaught from industry lobbyists? Or will the financial institutions use every conceivable means of avoid being classified as systemically important?

In any case, regulators will eventually take on the banks and their wayward behaviour. Once all the dust has settled, only one thing is certain: Banking profitability will end up being reduced structurally. Probably we should not mourn this development too much.