The 2007 financial crisis and the subsequent struggle to recover among developed countries have left a bitter taste in the mouths of the electorate of those countries. Understandably so. They have been left to bear the dual burden of paying to bail out those who caused the crisis, while at the same time having to struggle with a protracted recessionary environment.
Governments of developed economies have rallied around the idea of stricter regulation as the best way to both prevent future crises and punish institutions. The idea being that these governments - individually or in collaboration - will serve as judge and juror on the appropriate levels of risk for banks to be taking. If banks stick to these requirements, we shouldn't have to deal with such problems again. Or so the theory goes.
This remedy may prove adequate in the short- to medium-term, since we have a relatively good understanding now of why the 2007 crash happened. Irresponsible lending practices, coupled with absurd levels of leveraging on bank balance sheets created a situation where periods of high default were inevitable and, when it happened, banks had no margin of safety to be able to withstand it.
Understandably then, governments have asked banks to raise their capital requirements - though to lower levels than originally suggested - in order to expand their margin of safety.
Likewise, since the reason given for the fact that the banks were bailed out is that they were "too big to fail" governments have been looking into provisions which would require all investment banks to be split from commercial banks.
This strategy ignores, however, the extent to which regulators are at the whim of popular, short-term public opinion. The current political climate may be conducive to effective regulation but a brief look at the history of banking regulation, however, shows us why this approach will not work in the long-term. Throughout the history of financial markets, such regulations are inevitably eradicated by politicians lusting after increased economic growth to satisfy their electorate.
The situation of the bankers who caused the crisis is almost identical to that of the politicians who abandoned prudent financial regulations, such as the Glass-Steagal Act. They were placed in positions of enormous power and enormous opportunity, where their own personal incentives were divorced from that of their institutions.
Bankers were paid to lend en masse, not to build the future profitability of their institutions. The Presidential Administration was able to take credit for the booming economy, knowing that they would not be in office (or in the case of Members of Congress, would not be held personally accountable) for the resulting bust.
Not every banker or politician who assumes positions of power will put their own interests before the millions that they serve, but it stands to reason that eventually some will. As such, any lasting panacea for these problems must somehow align the interests of the leaders and the long-term interests of the people that they represent. For this reason, government regulation is not itself a complete solution.
As I see it, there are two ways to bring the interests of major banks into line with the individuals which run them:
1) Tying a proportion of any banking losses to the people that caused them. That is to say, whoever underwrote a loan which subsequently defaults, has a proportion of that loss taken from their own payment. This makes logical sense, since most banks already incentivise their employees for particularly profitable years. If employees share in the profits, sometimes to outrageous extents, why shouldn't they also share in some of the losses?
Of course, the problem with this approach is that corporate pay structures are typically set by banking executives (or people that they appoint) who have little incentive to set tough standards for themselves.
2) Having accepted that banks in the developed world are "too big to fail" we have inherently accepted that the public have a vested interest in ensuring that banks act in a responsible manner. That is, we have a right to regulate banks to ensure that they do not undertake unacceptably risky activities because, in doing so, they are potentially causing a significant public harm. Why then, is it not a criminal offense to cause a public harm such as the recent financial crisis?
If I were to fall asleep at the wheel of my car and kill someone I would likely serve time in prison, even though my actions were unintentional, because I took an unacceptable risk in driving when over-tired. Why are banking executives that brought a global banking system to its knees, and destroyed the lives of millions of people not held to the same standard?
Such a policy is not a witch-hunt to placate vengeful electorates – it incentivises senior banking executives to curb their risk to levels that there institutions can withstand, while leaving them free to pursue enough risk to oversee the kind of long-term profitability which is in the interests of both their institution and society.
Most importantly, for bank executives that have more money than they can ever hope to spend, and who find increasingly complex means of shielding it from the coffers of their governments, the loss of freedom is perhaps the only stick that the state can still hold over them.
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