In terms of their willingness to lend, the banks have gone from one extreme to the other. For Tim Harford – the Undercover Economist – such behaviour reminds him of something:
- “Like monstrous toddlers, the world’s banks have stumbled from manic exuberance, destroying all they touch with clumsy glee, to petulant refusal to get up off the floor. As any parent will tell you, round-the-clock supervision of toddlers is impossible and clearing up the crap is no fun...”
In an ideal world, misbehaving bankers would be fully exposed to the harsh discipline of the market place. However, as with toddlers, reality dictates a more interventionist approach:
- “The fundamental problem is that governments – rightly, given the present set-up – regard certain banks as too big or too interconnected to fail. In the last resort, they must be rescued lest the financial system as a whole be destroyed.”
In other words, until the banks are made to grow up, the state – and therefore the taxpayer – will be forever mopping up after them:
- “We need to return to a market-based system of banking regulation – one in which banks can be allowed to fail. In a market-based system, banks would need to reassure their backers that they were acting like grown-ups – a process likely to be more subtle and robust than ticking regulatory boxes.”
If banks were to raise more of their investment capital in the form of equity then they’d have more of their own money to lose – which should encourage more responsible behaviour. But banks prefer to risk other people’s money (by borrowing it and then lending it out again) and therefore won’t resort to equity unless told to by the state:
- “Regulators, then, are forced to craft rules to oblige banks to use enough equity capital. These rules do not work. Complex risk-weighted systems have failed utterly: again and again, banks have failed despite meeting regulatory requirements.”
However, there is another way:
- “A new debt contract, the ‘equity recourse note’ (ERN), is at the heart of a proposal by market veteran Jacob Goldfield and two economists, Jeremy Bulow and Paul Klemperer.
- “An equity recourse note would work like a traditional bond, except that at times of stress, the interest payments would be made in equity rather than cash. ‘Stress’ is defined not by regulators, who might hold back for fear of causing alarm, but by the bank’s share price.”
- “Let’s say the share price is $40 when the ERN is issued. The trigger price could be one quarter of that, or $10. At any point when payments were due but the share price was below $10, the payment would be made in shares instead, at a nominal price of $10. A $10,000 interest payment would instead be 1000 shares.”
What’s particularly clever about this proposal is that the state would only have to make one big decision – i.e. that "all unsecured bank debt must be in the form of ERNs." From that point on, the market would take over. For instance, should the bank in question get into trouble, those lending to it would be automatically ‘bailed-in’ according to the terms of the ERN.
Of course, with skin-in-the-game, it’s much less likely that investors would pump their money into poorly managed, reckless banks in the first place:
- “...investors would prefer to receive cash, not shares, and for this reason bankers would have to work hard to prove their honesty and competence. All this sounds refreshingly like grown-up market forces in action. Banking regulators should give it a try.”