A Blog by Jonathan Low

 

Jun 14, 2016

How Too Big To Fail Is Impeding Innovation

The basic argument is that the funding demands of big banks are starving the capital markets of risk capital necessary to invest in and then monetize innovation. JL

Izabella Kaminska reports in the Financial Times:

Solving the too-big-to-fail problem is a critical precondition to solving the productivity slump and for adjusting to a sustainable steady state.Without such an adjustment, the true cost of risk is obscured, preventing productive capital deployment or truly innovative developments (i.e those not focused on basic regulatory arbitrage).
Speeches from Paul Tucker, former deputy governor of the Bank of England, rarely disappoint in terms of insight, clarity and the pinpointing of factors which others dare not identify.
His keynote address to a Finance Watch conference on June 1 was no exception.
The prepared remarks can be found here, and the video — arguably even clearer — can be found here.
The crux of the message is this.
Financial resolution policy and technological innovation are intimately connected because without a well structured resolution policy finance has a habit of morphing into a peculiar form of asymmetrically socialised capitalism.

At the heart of the issue is how bank losses are dealt with.
These losses, says Tucker, must be taken somewhere. There’s no escape from that.
Since the only alternative to taxpayer-funded bailouts are those funded by private household balance sheets — whether that’s directly or indirectly by way of exposure to the insurance and pension funds industry — the focus must logically be on encouraging the private sector to underwrite banks to the full tune of their potential losses, and without taking advantage of unwitting creditors in the mix already.
It’s only then market forces will be able to price, value and adjust to the risks involved, whilst also encouraging a diversity of opinion and competition in the financial sector.
This is also why, says Tucker (in the video), he’s perturbed by rumours that the “flesh is weakening” with respect to the subordination of bank bondholders.
I worry, therefore, when I hear rumours that Europe will, in the event, not require subordination or that it might dilute the internationally agreed policy on minimum requirements.
As a matter of due process, Tucker argues, it is important that those bonds don’t rank equally with other senior creditors who — whether professionally or on a private level — only end up funding banks for the operational benefits rather than for investment purposes (such as trade creditors and uninsured depositors).
If the subordination of bondholders to the benefit of operational creditors doesn’t become a routine thing, the financial system will once again become dependent on bailouts. This time, stresses Tucker, sovereigns may be not be able to afford it.
On the flip side, if sufficient subordination does occur — a large enough quantity of such bonds to recapitalise the firm — bank bondholders will start charging in line with the riskiness of banks, asking for more information and improving price discovery in general.
But Tucker also lets onto another interesting point.
In his mind, solving the too-big-to-fail problem is a critical precondition to solving the productivity slump and for adjusting to a sustainable steady state.
Without such an adjustment, the true cost of risk is obscured, preventing productive capital deployment or truly innovative developments (i.e those not focused on basic regulatory arbitrage).
With the public no longer forced to underwrite without control, however, risk would finally get priced through the bond markets and change the terms of trade for under-capitalised banks.
The caveat is that it may take years for market forces to reshape finance and business models to account for the true cost of too-big-to-fail risk. According to Tucker, we may only be one third our way through the process:
The new regimes for banking, shadow banking and capital markets are not yet fully articulated; once they are, it will take years for intermediaries to tailor their business models, including their cost structures, to the new ‘rules of the game’; and no one will be able to judge the adequacy of the regime until they can observe its effects in a world of restored macroeconomic equilibrium.
All fair enough. Though what readers should also take away from the speech are some of the subtle admissions about the nature of the system as it stands.
For example, Tucker says without comprehensive resolution policy the ECB’s interventions can only “mask” a weakening recovery for so long.
He also notes greater private risk transfers are necessary to help the single-currency area better absorb regional economic shocks and to take pressure off the opaque official sector risk transfers that work through the TARGET payments system.
Last, he hints very strongly that what the banking industry doesn’t seem to get in its eternally protective stance and reluctance to accept the possibility of a higher cost of funding, is that the benefits of subordination don’t just benefit the public. They also benefit the industry by reducing the chances of a banking failure causing a social catastrophe, which kills the patient along with the disease, whilst also encouraging…
“….true technical progress in the economy, helping to overcome the productivity growth slump, with rewards for the winners, losses for the losers, and choice for the users.”

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