By Michael Lewis at Bloomberg
One of my favorite memories of my brief life on Wall Street in the late 1980s is of Mervyn King’s visit. A year after Professor King -- as I still think of him -- had been my tutor at the London School of Economics, he was tapped to advise some new British financial regulator. As he had no direct experience of financial markets, either he or they thought he’d benefit from exposure to real, live American financiers.
I’d been working at the London office of Salomon Brothers for maybe six months when one of my bosses came to me with a big eye roll and said, “We have this academic who wants to sit in with a salesman for a day: Can we stick him with you?” And in walked Professor King. I should say here that King’s students, including me, often came away from encounters with him feeling humored. He was gentle with people less clever than himself (basically everyone) and found interest in what others had to say when there was no apparent reason to. He really wanted you to feel as if the two of you were engaged in a genuine exchange of ideas, even though the only ideas with any exchange value were his.
Still, he had his limits. The man who a year before had handed me a gentleman’s B and probably assumed I would vanish into the bowels of the American economy never to be heard from again saw me smiling and dialing at my Salomon Brothers desk and did a double take. He took the seat next to me and the spare phone that allowed him to listen in on my sales calls. After an hour or so, he put down the phone. “So, Michael, how much are they paying you to do this?” he asked, or something like it. When I told him, he said something like, “This really should be against the law.”
Roughly 15 years later, King was named governor of the Bank of England. In his decade-long tenure, which ended in 2013, the Bank of England became, and remains, the most trustworthy institutional narrator of events in global finance. It’s the one place on the inside of global finance where employees don’t appear to be spending half their time wondering when Goldman Sachs is going to call with a job offer. For various reasons, they don’t play scared. One of those reasons, I’ll bet, is King.
Professor King -- or, if you must, Baron King of Lothbury -- has now written a book. “The End of Alchemy” isn’t a personal memoir of his tenure at the Bank of England. Actually, King seems disturbed by the idea that he or any other public servant is meant to be the hero of his own tale. “Many accounts and memoirs of the crisis have already been published,” he writes in his introduction. “Their titles are numerous, but they share the same invisible subtitle: ‘How I saved the world.’ ” Instead, King’s book draws on his experience of running a central bank -- and of managing a financial crisis -- to diagnose the ills of modern finance. Oddly enough, if his book gets the attention it deserves, it might just save the world.
King’s starting point is that the 2008 crisis wasn’t an anomaly but the natural consequence of bad incentives that are still baked into money and banking -- and so quite likely to create another, possibly even greater, crisis. “The strange thing,” he writes, “is that after arguably the biggest financial crisis in history nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.” The limited liability of shareholders still incentivizes them to allow the banks in which they invest to take greater risks than they would if they were forced to live with not just the gains from financial risk-taking but also the losses. Small depositors, whose funds are being turned into risky investments, are still covered by deposit insurance, so they could care less what the bankers do. Big depositors and anyone else who extends credit to banks still believe the bigger the bank the better, as the bigger the bank the greater the likelihood that the central bank will bail them out if things go wrong. (JPMorgan Chase today, King notes, has the same market share as the top 10 banks did collectively back in 1960.) That isn’t to say that nothing has been done, just that what’s been done is disturbingly beside the point.
The financial system, King reveals, is still wired so that a handful of well-connected people capture the benefits from risk-taking while the entire society bears the cost. Complexity was once used to disguise the risk in the financial system. Now it’s being used to disguise how little has actually been done to fix that system. Or, as King puts it, “Regulation has become extraordinarily complex, and in ways that do not go to the heart of the problem. … The objective of detail in regulation is to bring clarity, not to leave regulators and regulated alike uncertain about the current state of the law. Much of the complexity reflects pressure from financial firms. By encouraging a culture in which compliance with detailed regulation is a defense against a charge of wrongdoing, bankers and regulators have colluded in a self-defeating spiral of complexity.”
The way we do banking, King thinks, needs to change. As it turns out, he has a powerful idea for how to change it. “The End of Alchemy” is about more than this one idea -- which doesn’t actually appear until roughly 250 pages into the book. To the idea itself he devotes 40 seriously interesting pages, and I have here only a few hundred words. But this idea is the heart of his book and worth telling people about. So here goes:
The first thing that King thinks must be done is to separate the boring bits of banking (providing a safe place to deposit money, facilitating payments) from the exciting ones (trading). There is no need, he thinks, to break up the existing institutions. Deposits and short-term loans to banks simply need to be separated from other bank assets. Against all of these boring assets, banks would be required to hold government bonds or reserves at the central bank in cash. That is, there should be zero risk that there won’t be sufficient cash on hand to repay people wanting to flee any bank at a moment’s notice -- and thus no reason for those people to flee.
The riskier assets from which banks stand most to gain (and lose) would then be vetted by the central bank, in advance of any crisis, to determine what it would be willing to lend against them in a pinch if posted as collateral. Common stocks, mortgage bonds, Australian gold mines, credit default swaps and whatever else: The banks would decide, before any crisis, which of their risky assets they would be willing to pledge to -- basically, pawn with -- the central bank. The riskier the asset, the less the central bank would be willing to lend against it. Any asset so complicated that it couldn’t be explained satisfactorily to the central bank in three 15-minute presentations wouldn’t be eligible as collateral. Everyone would know, if any given bank ever required a loan from the central bank, the size of the loan the central bank would be willing to extend. The central bank would go from being the lender of last resort to what King calls the pawnbroker for all seasons.
It would also have a handy, simple rule to determine if any given bank is solvent: the difference between its “effective liquid assets” and its “effective liquid liabilities.” The effective liquid assets would consist of the securities the bank held against its deposits (government bonds, cash), plus the collateral value of its riskier bets as judged by the central bank. The effective liquid liabilities would be the money that could run from the bank at short notice -- deposits and loans of less than one year made to the bank. The rule -- call it the King Rule -- would be that a bank’s effective liquid assets must exceed its effective liquid liabilities. If they don’t, the bank is insolvent, and its deposits would be moved without any panic or trouble to a bank that isn’t.
“Consider a simple example of a bank with total assets and liabilities each equal to $100 million,” King writes:
Suppose that it has $10 million of assets in the form of reserves at the central bank, $40 million in holdings of relatively liquid securities and $50 million in the form of illiquid loans to businesses. If the central bank decided that the appropriate haircut on the liquid securities was 10 percent and on the illiquid loans was 50 percent, then it would be willing to lend $36 million against the former and $25 million against the latter, provided that the bank pre-positioned all its assets as available collateral. The bank’s effective liquid assets would be $(10 + 36 + 25) million, a total of $71 million. It would have to finance itself with no more than $71 million of deposits and short-term debt.
That example shows one big effect of the King Rule: It would encourage banks to finance themselves with a lot more equity and long-term debt than they do. It would discourage them from engaging in lots of economically pointless speculative activity, because they would pay the full price for that activity in the form of haircuts on their collateral. With those haircuts, the banks would be paying upfront a fair price for the liquidity insurance that they don’t pay for now. The troubling incentive they now have to grow bigger -- because the bigger they are, the more likely they’ll be bailed out -- would be removed, as there would be no bailouts. In the event of failure, there would be no need for depositors to run for their money, because all deposits would be backed by government collateral. All losses would be eaten by the shareholders and long-term creditors. The King Rule would push financial people back where they belong: into a market where failure is as possible as it is in the rest of the economy. The quality that the stock market would probably come to prize most in banks is safety. Banks would likely end up both less profitable and more boring. But as it would be left to the market to decide how best to structure the riskier parts of banks’ operations, there would be incentives to improve and innovate.
In the bargain, banks would be a lot simpler to regulate. (“There would be no panic rescues over a weekend, no dramatic tales to retell in subsequent memoirs.”) The King Rule -- which he suggests might be implemented gradually, over, say, a decade -- would replace thousands of pages of incomprehensible financial regulation in a stroke. It would expand the role of central bankers, but in the direction it has been heading since the crisis. Instead of lending frantically against overvalued collateral in the next crisis, the central bank would pledge to lend calmly against fairly valued collateral.
Of course the people at the central bank in charge of valuing the collateral would likely come under political pressure to do this job badly -- to value collateral more highly than it should be valued, for instance, or favor certain kinds of collateral over others. “But central bankers are in a stronger position to resist such calls in normal times than after the crisis has hit,” King writes. Plus they need only be roughly right and seek to err on the conservative side -- and ignore all arguments that government regulators have no business meddling in private affairs of big banks. “In the heat of the crisis in October 2008, nation states took over the responsibility for all the obligations and debts of the global banking system,” he writes. “That government rescue cannot conveniently be forgotten. When push came to shove, the very sector that had espoused the merits of market discipline was allowed to carry on only by dint of taxpayer support.”
King says a lot more; really you should read the book. If nothing else, you will come away from it with the sense that someone with expert knowledge of the deep problems in our financial system is actually trying to solve them. It’s interesting in the aftermath of the crisis how much energy has been expended seeming to fix the problem without attacking it head-on. Much as they moan and groan about their reduced circumstances, our biggest bankers are still playing a game of heads-I-win, tails-you-lose with the rest of the society.
They may not come out quite as well as before if the coin comes up heads, and we might not lose quite so badly if it comes up tails; but the game hasn't really changed. A former governor of the Bank of England thinks we need to change the relationship between our banks and our society, and fast. Most of us would be better off if we took his advice.