A Sim­ple Plan to Save the World

Uhh Umm No Gramm-leach-bliley Act of 1999 :( Gold Cdo-squared Big Bang of 1986 Great Moder­a­tion o N No De­fla­tion In­ter­nal de­val­u­a­tion Yikes Trans­mu­ta­tion No *s i g h * Ew ! W h a t ? Enough! Short-term bor­row­ing Swaps Col­lat­er­al­ized debt obli­ga­tions R

Bloomberg Businessweek (North America) - - Opening Remarks - By Michael Lewis

One of my fa­vorite mem­o­ries of my brief life on Wall Street in the late 1980s is of Mervyn King’s visit. A year after Pro­fes­sor King—as I still think of him—had been my tu­tor at the Lon­don School of Eco­nom­ics, he was tapped to ad­vise some new Bri­tish fi­nan­cial reg­u­la­tor. As he had no di­rect ex­pe­ri­ence of fi­nan­cial markets, ei­ther he or they thought he’d ben­e­fit from ex­po­sure to real, live Amer­i­can fi­nanciers.

I’d been work­ing at the Lon­don of­fice of Salomon Brothers for maybe six months when one of my bosses came to me with a big eye roll and said, “We have this aca­demic who wants to sit in with a sales­man for a day: Can we stick him with you?” And in walks Pro­fes­sor King. I should say here that King’s stu­dents, in­clud­ing me, of­ten came away from en­coun­ters with him feel­ing hu­mored. He was gen­tle with peo­ple less clever than him­self ( ba­si­cally ev­ery­one) and found in­ter­est in what oth­ers had to say when there was no ap­par­ent rea­son to. He re­ally wanted you to feel as if the two of you were en­gaged in a gen­uine ex­change of ideas, even though the only ideas with any ex­change value were his.

Still, he had his lim­its. The man who a year be­fore had handed me a gen­tle­man’s B and prob­a­bly as­sumed I would van­ish into the bow­els of the Amer­i­can econ­omy never to be heard from again saw me smil­ing and di­al­ing at my Salomon Brothers desk and did a dou­ble take. He took the seat next to me and the spare phone that al­lowed him to lis­ten in on my sales calls. After an hour or so, he put down the phone. “So, Michael, how much are they pay­ing you to do this?” he asked, or some­thing like it. When I told him, he said some­thing like, “This re­ally should be against the law.”

Roughly 15 years later, King was named gov­er­nor of the Bank of Eng­land. In his decade-long ten­ure, which ended in 2013, the Bank of Eng­land be­came, and re­mains, the most trust­wor­thy in­sti­tu­tional nar­ra­tor of events in global fi­nance. It’s the one place on the in­side of global fi­nance where em­ploy­ees don’t ap­pear to be spend­ing half their time won­der­ing when Gold­man Sachs is go­ing to call with a job of­fer. For var­i­ous rea­sons, they don’t play scared. One of those rea­sons, I’ll bet, is King.

Pro­fes­sor King—or, if you must, Baron King of Loth­bury—has now writ­ten a book. The End of Alchemy isn’t a per­sonal mem­oir of his ten­ure at the Bank of Eng­land. Ac­tu­ally, King seems dis­turbed by the idea that he or any other pub­lic

ser­vant is meant to be the hero of his own tale. “Many ac­counts and mem­oirs of the cri­sis have al­ready been pub­lished,” he writes in his in­tro­duc­tion. “Their ti­tles are nu­mer­ous, but they share the same in­vis­i­ble sub­ti­tle: ‘How I saved the world.’ ” In­stead, King’s book draws on his ex­pe­ri­ence of run­ning a cen­tral bank—and of man­ag­ing a fi­nan­cial cri­sis—to di­ag­nose the ills of mod­ern fi­nance. Oddly enough, if his book gets the at­ten­tion it de­serves, it might just save the world.

King’s start­ing point is that the 2008 cri­sis wasn’t an anom­aly but the nat­u­ral con­se­quence of bad in­cen­tives that are still baked into money and bank­ing—and so quite likely to cre­ate an­other, pos­si­bly even greater, cri­sis. “The strange thing,” he writes, “is that after ar­guably the big­gest fi­nan­cial cri­sis in his­tory noth­ing much has re­ally changed in terms ei­ther of the fun­da­men­tal struc­ture of bank­ing or the re­liance on cen­tral banks to re­store macroe­co­nomic pros­per­ity.” The lim­ited li­a­bil­ity of share­hold­ers still in­cen­tivizes them to al­low the banks in which they in­vest to take greater risks than they would if they were forced to live with not just the gains from fi­nan­cial risk-tak­ing but also the losses. Small de­pos­i­tors, whose funds are be­ing turned into risky in­vest­ments, are still cov­ered by de­posit in­surance, so they could care less what the bankers do. Big de­pos­i­tors and any­one else who ex­tends credit to banks still be­lieve the big­ger the bank the bet­ter, as the big­ger the bank the greater the like­li­hood that the cen­tral bank will bail them out if things go wrong. ( Jpmor­gan Chase to­day, King notes, has the same mar­ket share as the top 10 banks did col­lec­tively back in 1960.) That isn’t to say that noth­ing has been done, just that what’s been done is dis­turbingly be­side the point.

The fi­nan­cial sys­tem, King re­veals, is still wired so that a hand­ful of well­con­nected peo­ple cap­ture the ben­e­fits from risk- tak­ing while the en­tire so­ci­ety bears the cost. Com­plex­ity was once used to dis­guise the risk in the fi­nan­cial sys­tem. Now it’s be­ing used to dis­guise how lit­tle has ac­tu­ally been done to fix that sys­tem. Or, as King puts it, “Reg­u­la­tion has be­come ex­traor­di­nar­ily com­plex, and in ways that do not go to the heart of the prob­lem. … The ob­jec­tive of de­tail in reg­u­la­tion is to bring clar­ity, not to leave reg­u­la­tors and reg­u­lated alike un­cer­tain about the cur­rent state of the law. Much of the com­plex­ity re­flects pres­sure from fi­nan­cial firms. By en­cour­ag­ing a cul­ture in which com­pli­ance with de­tailed reg­u­la­tion is a de­fense against a charge of wrong-do­ing, bankers and reg­u­la­tors have col­luded in a self­de­feat­ing spi­ral of com­plex­ity.”

The way we do bank­ing, King thinks, needs to change. As it turns out, he has a pow­er­ful idea for how to change it. The End of Alchemy is about more than this one idea—which doesn’t ac­tu­ally ap­pear un­til roughly 250 pages into the book. To the idea it­self he de­votes 40 se­ri­ously in­ter­est­ing pages, and I have here only a few hun­dred words. But this idea is the heart of his book and worth telling peo­ple about. So here goes:

The first thing that King thinks must be done is to sep­a­rate the bor­ing bits of bank­ing (pro­vid­ing a safe place to de­posit money, fa­cil­i­tat­ing pay­ments) from the ex­cit­ing ones (trad­ing). There is no need, he thinks, to break up the ex­ist­ing in­sti­tu­tions. De­posits and short-term loans to banks sim­ply need to be sep­a­rated

from other bank as­sets. Against all of these bor­ing as­sets, banks would be re­quired to hold gov­ern­ment bonds or re­serves at the cen­tral bank in cash. That is, there should be zero risk that there won’t be suf­fi­cient cash on hand to re­pay peo­ple want­ing to flee any bank at a mo­ment’s no­tice—and thus no rea­son for those peo­ple to flee.

The riskier as­sets from which banks stand most to gain (and lose) would then be vet­ted by the cen­tral bank, in ad­vance of any cri­sis, to de­ter­mine what it would be will­ing to lend against them in a pinch if posted as col­lat­eral. Com­mon stocks, mort­gage bonds, Aus­tralian gold mines, credit-de­fault swaps, and what­ever else: The banks would de­cide, be­fore any cri­sis, which of their risky as­sets they would be will­ing to pledge to—ba­si­cally, pawn with—the cen­tral bank. The riskier the as­set, the less the cen­tral bank would be will­ing to lend against it. Any as­set so com­pli­cated that it couldn’t be ex­plained sat­is­fac­to­rily to the cen­tral bank in three, 15-minute pre­sen­ta­tions wouldn’t be el­i­gi­ble as col­lat­eral. Ev­ery­one would know, if any given bank ever re­quired a loan from the cen­tral bank, the size of the loan the cen­tral bank would be will­ing to ex­tend. The cen­tral bank would go from be­ing the lender of last re­sort to what King calls the pawn­bro­ker for all sea­sons.

It would also have a handy, sim­ple rule to de­ter­mine if any given bank is sol­vent: the dif­fer­ence be­tween its “ef­fec­tive liq­uid as­sets” and its “ef­fec­tive liq­uid li­a­bil­i­ties.” The ef­fec­tive liq­uid as­sets would con­sist of the se­cu­ri­ties the bank held against its de­posits (gov­ern­ment bonds, cash), plus the col­lat­eral value of its riskier bets as judged by the cen­tral bank. The ef­fec­tive liq­uid li­a­bil­i­ties would be the money that could run from the bank at short no­tice— de­posits and loans of less than one year made to the bank. The rule, call it the King Rule, would be that a bank’s ef­fec­tive liq­uid as­sets must ex­ceed its ef­fec­tive liq­uid li­a­bil­i­ties. If they don’t, the bank is in­sol­vent, and its de­posits would be moved with­out any panic or trou­ble to a bank that isn’t.

“Con­sider a sim­ple ex­am­ple of a bank with to­tal as­sets and li­a­bil­i­ties each equal to $100 mil­lion. Sup­pose that it has $ 10 mil­lion of as­sets in the form of re­serves at the cen­tral bank, $ 40 mil­lion in hold­ings of rel­a­tively liq­uid se­cu­ri­ties and $50 mil­lion in the form of illiq­uid loans to busi­nesses. If the cen­tral bank de­cided that the ap­pro­pri­ate hair­cut on the liq­uid se­cu­ri­ties was 10 per­cent and on the illiq­uid loans was 50 per­cent, then it would be will­ing to lend $36 mil­lion against the former and $25 mil­lion against the lat­ter, pro­vided that the bank pre-po­si­tioned all its as­sets as avail­able col­lat­eral. The bank’s ef­fec­tive liq­uid as­sets would be $(10+36+25) mil­lion, a to­tal of $71 mil­lion. It would have to fi­nance it­self with no more than $71 mil­lion of de­posits and short-term debt.”

That ex­am­ple shows one big ef­fect of the King Rule: It would en­cour­age banks to fi­nance them­selves with a lot more eq­uity and long-term debt than they do. It would dis­cour­age them from en­gag­ing in lots of eco­nom­i­cally point­less spec­u­la­tive ac­tiv­ity, be­cause they would pay the full price for that ac­tiv­ity in the form of hair­cuts on their col­lat­eral. With those hair­cuts, the banks would be pay­ing up­front a fair price for the liq­uid­ity in­surance that they don’t pay for now. The trou­bling in­cen­tive they now have to grow big­ger—be­cause the big­ger they are, the more likely they’ll be bailed out—would be re­moved, as there would be no bailouts. In the event of fail­ure, there would be no need for de­pos­i­tors to run for their money, be­cause all de­posits would be backed by gov­ern­ment col­lat­eral. All losses would be eaten by the share­hold­ers and long-term cred­i­tors. The King Rule would push fi­nan­cial peo­ple back where they be­long, into a mar­ket where fail­ure is as pos­si­ble as it is in the rest of the econ­omy. The qual­ity that the stock mar­ket would prob­a­bly come to most prize in banks is safety. Banks would likely end up both less prof­itable and more bor­ing. But as it would be left to the mar­ket to de­cide how best to struc­ture the riskier parts of banks’ op­er­a­tions, there would be in­cen­tives to im­prove and in­no­vate.

In the bar­gain, banks would be a lot sim­pler to reg­u­late. (“There would be no panic res­cues over a week­end, no dra­matic tales to retell in sub­se­quent mem­oirs.”) The King Rule— which he sug­gests might be im­ple­mented grad­u­ally, over, say, a decade—would re­place thou­sands of pages of in­com­pre­hen­si­ble fi­nan­cial reg­u­la­tion in a stroke. It would ex­pand the role of cen­tral bankers but in the di­rec­tion it has been head­ing since the cri­sis. In­stead of lend­ing fran­ti­cally against over­val­ued col­lat­eral in the next cri­sis, the cen­tral bank would pledge to lend calmly against fairly val­ued col­lat­eral.

Of course the peo­ple at the cen­tral bank in charge of valu­ing the col­lat­eral would likely come un­der po­lit­i­cal pres­sure to do this job badly—to value col­lat­eral more highly than it should be val­ued, for in­stance, or fa­vor cer­tain kinds of col­lat­eral over oth­ers. “But cen­tral bankers are in a stronger po­si­tion to re­sist such calls in nor­mal times than after a cri­sis has hit,” King writes. Plus they need only be roughly right and seek to err on the con­ser­va­tive side—and ig­nore all ar­gu­ments that gov­ern­ment reg­u­la­tors have no busi­ness med­dling in pri­vate af­fairs of big banks. “In the heat of the cri­sis in Oc­to­ber 2008 na­tion states took over the re­spon­si­bil­ity for all the obli­ga­tions and debts of the global bank­ing sys­tem,” he writes. “That gov­ern­ment res­cue can­not con­ve­niently be for­got­ten. When push came to shove, the very sec­tor that had es­poused the mer­its of mar­ket dis­ci­pline was al­lowed to carry on only by dint of tax­payer sup­port.”

King says a lot more; re­ally you should read the book. If noth­ing else, you will come away from it with the sense that some­one with ex­pert knowl­edge of the deep prob­lems in our fi­nan­cial sys­tem is ac­tu­ally try­ing to solve them. It’s in­ter­est­ing in the af­ter­math of the cri­sis how much en­ergy has been ex­pended seem­ing to fix the prob­lem with­out at­tack­ing it head on. Much as they moan and groan about their re­duced cir­cum­stances, our big­gest bankers are still play­ing a game of heads-i-win, tails-you-lose with the rest of the so­ci­ety. <BW>

ex­ter­nal deficit by de­pre­ci­at­ing ster­ling and squeez­ing im­ports.

Lon­don’s role in in­ter­na­tional fi­nance is an­other vul­ner­a­bil­ity. Some 7 per­cent of U.K. eco­nomic out­put comes from fi­nan­cial ser­vices—11 per­cent if you in­clude re­lated le­gal, ac­count­ing, and man­age­ment- con­sult­ing ser­vices. Bank of Eng­land Gov­er­nor Mark Car­ney has rightly stressed the risk that Brexit poses to this part of the econ­omy.

The prob­lem for the exit cam­paign is not just that it’s re­fus­ing to take these dan­gers se­ri­ously, but that its lead­ing fig­ures have no agreed plan for the kind of trade agree­ments, if any, they would seek after leav­ing. Rather than de­scrib­ing a po­lit­i­cally vi­able al­ter­na­tive to EU mem­ber­ship, they of­fer heroic spec­u­la­tion, and, when pressed for de­tails, start quar­rel­ing among them­selves.

To read Vir­ginia Postrel on tip­ping (or not tip­ping) Uber driv­ers and Justin Fox on surg­ing R&D spend­ing, go to

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