Our paradigm of banking regulation is shot

Sir Andrew Crockett is a highly respected economist and banker. He came to Melbourne in 1999 in the aftermath of the “Asian Crisis”. At the time he was chairman of the Bank for International Settlements (the central bank to the world’s central banks). He said the world’s financial architecture was fundamentally sound, and only the plumbing needed fixing. This just goes to show you shouldn’t hire an economist to design your house.

Since his address, the international financial edifice has been shaken to its foundations. China owns America’s debt. Barack Obama is now the world’s number one auto exec. Whole suburbs lie abandoned in America, and Gordon Brown thought it necessary to use anti-terrorism legislation to threaten a bankrupt Iceland.

What a calamity! The malpractices that caused this were many and varied. They included: ineffective tax cuts in the US enacted by an economically illiterate president; the deflationary effects of the dotcom bubble’s burst and the subsequent expansion of money supply by the US Fed; dodgy ratings provided by some of the most “respected” ratings agencies, including Moody’s; the growth of the non-bank financial sector, or so-called “shadow-banking”; the property bubble in the US that gave rise to dubious financial instruments such as the notorious low-documentation liar loans; the over-inflated salaries paid to CEOs, which weakened the very companies they were entrusted to lead; and, last and most importantly, a lack of enforcement of banking regulations.

Despite constant reassurances by treasurers and central bankers the world over, confidence in our banking system has taken a severe hit. Shareholders and consumers have learned the hard way that bankrupt banks take the rest of the economy down with them. Banking regulations are designed to prevent this. However, they are notoriously difficult to enforce, and attempts to do so are littered with spectacular failures. To name but a few: the Savings and Loans Crisis; the Asian Crisis; Iceland’s collapse; the failures of Royal Bank of Scotland, Northern Rock, and closer to home, Tri-continental, State Bank of SA, Pyramid, HIH and Tower Life; and now, the Global Financial Crisis.

And what was the response to this series of stuff-ups? An ever greater determination to rely on the state to regulate banks. The only thing more stubborn than a failing regulator is our determination to allow those failing regulators to continue to fail! Joseph Stiglitz, Nobel Laureate and chairman of Bill Clinton’s Council of Economic Advisors has even suggested an international bank regulator. Tower of Babel meets Yes Minister!

So what is the solution? Well, first we should adopt the Alcoholics Anonymous strategy and admit we have a problem. Our paradigm of banking regulation is shot. So, instead of continuing to flog this decomposing horse, let’s try something else, like Deposit Only Liability Insurance (DOLI). Under this scheme, every bank would have to insure a percentage of all depositors’ funds with an insurance company. In return, the insurer would receive a premium. To determine the premium the insurer would conduct a due diligence assessment of the bank’s practices. The insurer might wish to use all or part of existing bank regulations, such as capital adequacy requirements, to assess the bank’s robustness.

As the bank’s risk profile rises, so does the premium, and vice versa. If the bank cannot obtain insurance then it must cease to operate. If the bank goes bankrupt, it’s the insurer’s problem and the re-insurer’s problem; not the taxpayers’! As for whether an insurer would undertake the risk, insurers are in the business of providing insurance in return for a premium. So long as they can assess the risk and quantify the premium, insurers will insure against earthquakes. So why not insure a bank against insolvency? By insuring only depositors we do not run into the moral hazard created by insuring shareholders.

The advantages of this system are many. A rise in the price of the premium is easier for a banker to understand than lots of complex laws which have only a possibility of enforcement. A promise of a decrease in the premium is far more effective an incentive than the government attempting to enforce regulations, most of which were enacted in response to the last problem, not the current problem. Besides, national regulations are a blunt instrument for influencing the trade of highly sophisticated financial products that are bought and sold trans-nationally.

Put simply DOLI envisages sub-contracting the job of banking regulation, and selling the state’s liability to bail out banks to an insurer, in return for a premium. Will DOLI work? Maybe it will, maybe it won’t. As for the present system - no doubt there whether it will or it won’t. It’s simple. It don’t.