Fixing finance

There are good reasons why the public has lost confidence in banking and finance. Two issues in particular must be addressed before it can be restored– moral hazard and conflict of interest. Reforms should ensure that banks and bankers–not taxpayers–pay the price of failure and are held fully accountable for their actions.

Confidence in the financial sector has taken some sharp hits since the financial crisis started: subprime mortgages traded as triple-A investments, trillions in bailouts and lost output, rogue traders losing their banks billions, the Libor rate-fixing scandal, etc. All these scandals revolve to a large extent around the two main shortcomings that afflict the financial sector: moral hazard and conflict of interest.

The first issue, moral hazard, refers to a situation where someone has an incentive to take a bigger risk because they know someone else will pay the bill if it doesn’t pay off. In short, “heads I win, tails you lose!” In the financial sector, this issue is everywhere. On the trading floor, traders get a nice bonus if their risks pay off; if they don’t, it’s their employer or client who bears the loss. At the top of the hierarchy, chief executives at big global banks get vast bonuses when they are successful and attractive severance packages when they leave, sometimes even when they have done a poor job. At a macroeconomic level, banks that are “too big to fail” can reap great profits from bets that go well, whereas losses that threaten their existence are borne by taxpayers in the form of bailouts.

Let’s take a closer look at bailouts. Traditional commercial banks provide essential services throughout our economies: supplying loans to businesses and families, safeguarding savings and providing payment services. Letting a big commercial bank go bankrupt is therefore a risk that no government wants to take. However, in today’s financial system, big commercial banks are usually also big investment banks engaging in a totally different type of banking, which tends to be more risky and speculative. On average, large European banks dedicate less than 30% of their balance sheet to lending to households and nonfinancial companies and institutions. When the investment-banking arm of these universal banks pushes them over the edge in a catastrophic scenario, governments have no choice but to bail them out in order to avoid major disruptions in the functioning of the economy. To make things worse, the high degree of interconnectedness in the financial sector means that even pure investment banks need public guarantees if they are considered big enough to pull universal banks down with them.

Universal banks, especially those deemed “too big to fail” or “systemically important”, thus enjoy an implicit government guarantee. This makes them a less risky option for lenders and thereby drives down their borrowing cost compared to smaller or more specialised banks. This distorts not only competition, but also the very funding structure of banks: on average, European commercial banks need to finance 15% of their loans with wholesale funding to bridge the gap with deposits, whereas their trading activities bring this proportion to 50%. As wholesale funding is by its nature more volatile than deposits, the combination of both activities (lending and trading) leads to increased volatility in the funding structure of universal banks as a whole, including their commercial banking activities. To put it simply, the implicit government guarantee gives large universal banks an incentive to leverage their balance sheets to the detriment of traditional commercial banking activities. In good times, taxpayers benefit very little from the guarantee they provide but, in times of crisis, they pay heavily. In short: private gains, public losses.

©Reuters/Lucas Jackson

Putting an end to moral hazard is essential. This requires, among other things, a clear separation of commercial and investment banking activities to ensure that taxpayers are insulated from providing a guarantee for risky and speculative activities. Such a separation could actually give an impulse to economic growth and increase the competitiveness of the financial sector thanks to its impact on banks’ size and complexity. Indeed, it would shrink both the size of banks and the banking sector as a whole, which, as a recent study from the Bank for International Settlements (BIS) shows, would have a positive impact on economic growth. Either way, the simple argument that banks should be able to absorb losses or even go bankrupt without pulling down the entire economy is incontestable.

At the European level, a high-level expert group led by Erkki Liikanen, the governor of the Bank of Finland, has advised the European Commission to take steps towards a separation of trading activities. At Finance Watch we applaud this recommendation, even though we fear that it does not go far enough. It is therefore crucial that these proposals be understood as a strict minimum among the reforms needed.

The second issue that needs to be tackled to restore trust is conflict of interest, which is ubiquitous in the financial sector. Take the Libor scandal: banks are asked to submit the interest rates they have been paying for their short-term financing. At the same time, they hold financial instruments whose value is determined by Libor, and they depend on Libor for their financing costs. The rate, therefore, has a significant impact on their profitability. Influencing Liborby fabricating quotes then becomes a temptation.

Another example of conflict of interest can be seen with financial advisors. In many, if not most, cases, a financial advisor has strong financial incentives to steer clients in a direction that does not serve their best interests. When an advisor gains financially from promoting certain products, he or she becomes nothing but a salesperson in disguise.

To tackle conflict of interest, regulation is needed that blocks or neutralises perverse incentives. Also, within financial institutions, employees, management and executives must be held responsible for their acts, as well as the corporation itself.

The public has lost confidence in our banks since 2008, and not without justification. Despite this, far-reaching reforms are still lacking, meaning that for many banks post-crisis banking is business as usual. Both moral hazard and conflict of interest remain pervasive. But the problem is by no means set in stone, and the solution today involves changing the rules of the game. A new framework for the financial sector would benefit everyone in the long run: citizens and entrepreneurs would operate in a less crisisprone economic environment, bankers would be able to win back the trust of the public and of investors, and regulators would not have to worry about losing control over a Leviathan financial sector that can pull down the world economy.

References and recommended sources

Finance Watch

Cecchetti, S.G. and E. Kharroubi (2012), “Reassessing the impact of finance on growth”, BIS Working Papers No. 381, BIS, Basel.

Liikanen, E. et al. (2012), High-Level Expert Group on Reforming the Structure of the EU Banking Sector, Final report, European Commission, Brussels.

OECD work on finance

OECD work on taxation