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Op-ed

The Future of Banking: Is More Regulation Needed?

by Peter Boone, London School of Economics
and Simon Johnson, Peterson Institute for International Economics

Op-ed for the Financial Times
April 10, 2011

© Financial Times

If the April 11, 2011 interim report of Sir John Vickers' Independent Commission on Banking highlights one thing, it must be this: The banking system, on both sides of the Atlantic, is more dangerous now than before the financial crisis began in 2008. The only difference is that few now think Citi, HSBC, or any of the major banks could go bankrupt, like Lehman Brothers. Before 2008 "too big to fail" guarantees were a possibility; now they are a certainty—enabling banks to borrow cheaply and take risky bets with a great deal of leverage. Executives get the upside, taxpayers get the downside.

Net US federal government debt now held by the private sector—seen by comparing Congressional Budget Office forecasts before and after the crisis—has increased by 40 percentage points to around 75 percent of GDP. This is the heart of the immediate American fiscal crisis. Yet the political power of these banks in the United States has actually risen—while in most European countries the biggest banks are also untouched. All sensible proposals to tame the sector have been declined. Jamie Dimon, JPMorgan Chase chief executive, argued in November 2009 that "too big to fail" could not be ended without a "resolution authority" for megabanks—an expansion of the power to manage orderly liquidation and impose losses on creditors. The Dodd-Frank reform legislation in the United States creates such an authority but with a big loophole: It does not apply to cross-border banks like JPMorgan or Citi. There is no cross-border resolution mechanism of any kind and none planned. For megabanks in trouble, the choice remains: Lehman-type collapse or TARP-type bailout.

Vikram Pandit, Citigroup's CEO, reduced the size of his bank in 2009—admittedly under pressure from the government, his largest shareholder. But when broader size and leverage caps on banks were floated in early 2010, Citi and all the other banks fought back hard—and the measure failed on the floor of the Senate. Mr. Pandit and Mr. Dimon now tout their new expansion plans into emerging markets—building bigger and more global highly leveraged financial services firms. Amazingly, they are cheered on by the US authorities.

Tim Geithner, US Treasury secretary, argued in 2009 that the right response was "capital, capital, capital." But Basel III will end up with capital requirements for systemically important institutions no higher than that reported by Lehman the day before it failed. In Europe, the situation is just as dangerous. The European Central Bank is unwilling to support losses for senior creditors at egregiously mismanaged Irish banks. This, along with weak stress tests, means banks, no matter how riskily capitalized, now have cheap and easy credit.

In the United Kingdom, the Vickers Commission will presumably recommend "higher" capital requirements. But will Britain raise requirements to the new Swiss levels of 19 percent or beyond? The economics says they should, but the bankers will fight tooth and nail—it is their compensation on the line, after all.

The consensus view is that none of this matters much in the short run, because banks are now more careful and their supervisors could not make the same kind of mistake twice. This view is wrong. The high price of credit makes it hugely attractive for financial institutions to engage in the same activities that sank Lehman and AIG. When banks have too little capital, tough regulation has the deleterious effect of making it highly profitable to avoid and evade the regulator. The market is now pressing banks to take more risks, and banks are responding. Regulators are no better able today to see this than they were in the pre-Lehman era. Citi, for instance, has blown itself up three times in the past 30 years: in 1982, from bad loans to emerging markets; in the late 1980s, from US commercial real estate; and in 2008–09, from US residential real estate. Vickers or no Vickers, without serious reform, it will soon be a case of here we go again.

Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.

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Op-ed

The Future of Banking: Is More Regulation Needed?