December 12, 2010

Mervyn King calls us to the Old Lady's deathbed?

I've been watching an odd series of posts over in UK's Finanser site with amusement:

All along the lines of,

Add to that the fact that securitization renders banking a historical inefficiency, and central banking a vestigial cost structure (see the impromptu series on the end of banking, I, II, III).

It's time to change the music, but I've predicted that nobody's going to be the first to say that.

I spoke too soon. Last month, Hasan pointed to Mervyn King again, who's just come out and said:

"One might well say that a financial crisis occurs when the Basel risk weights turn out to be poor estimates of underlying risk. And that is not because investors, banks or regulators are incompetent. It is because the relevant risks are often impossible to assess in terms of fixed probabilities. Events can take place that we could not have envisaged, let alone to which we could attach probabilities. If only banks were playing in a casino then we probably could calculate appropriate risk weights. Unfortunately, the world is more complicated. So the regulatory framework needs to contain elements that are robust with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements."

In short, what the Governor is saying is that Basel III is not the answer. It might be part of the answer, but he's raising some skepticism. Then, he discusses solutions:

"Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity - that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009).

Blink and you missed it! The end of fractional reserve banking? On the table?

In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such "gambling" to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.

So there we have the reversion to Glass-Steagall and removal of deposit taking from risk-making, or as he puts it, kicking the payments system out of banks' jurisdiction. My words fail, so back to his:

We certainly cannot rely on being able to expand the scope of regulation without limit to prevent the migration of maturity mismatch. Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy. It will not be possible to regulate all parts of the financial system as if they were banks. ...

Which in effect is a fall-back to Glass-Steagal, but this time there is a recognition of something called the migration of maturity mismatch. Innovation might be the cassus belli above, but securitization is firmly in Mr King's sites.

But, wait, there's more! Across the pond, Mr King reports that they're talking about redeeming the implied public subsidy of lender of last resort:

As Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, has argued, "merely expanding the scope of regulation to chase those firms that extract implicit guarantees by engaging in maturity transformation would be an interminable journey with yet more financial instability in its wake" (Lacker, 2010).

For "implicit guarantee" read lender of last resort. For "maturity transformation" read securitization, CDOs and the shift from banking to market.

It's happening. Jeffrey Lacker of the Fed has called for a stop to the lender of last resort, and the Governor of the world's first central bank has put it on the table for negotiation. In effect, they're throwing in the towel. In speech celebrating the inventor of the central bank, Mervyn King has called the beginning and the end of an era of financial history.

Central banking is on its last legs, the Old Lady of Threadneedle Street is on her deathbed.

What remains is to give her a decent burial, and preserve our economy in her wake. The shift from Banking to Markets continues, apace.

  1. What banking is. (Essential for predicting the end of finance as we know it.)

  2. What caused the financial crisis. (Laying bare the end of banking.)

  3. A small amount of Evidence. (In which, the end of banking and the rise of markets is suggested.)

  4. Mervyn King calls us to the Old Lady's deathbed?

  5. (Introducing the death of the partner and the central bank as turbocharger as 2 new causes)

Posted by iang at December 12, 2010 08:37 AM | TrackBack
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