Friday, December 26, 2008

Banking Regulation - Buyer Beware

This post on bank and financial regulation has been under consideration for a long time. The reason why it has taken so long is that I was allowing myself to become confused, in much the same way most people become confused over these issues. The cause of this confusion is that we all seem to forget what the financial and banking system is, and what it does.

The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.

I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.

The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.

Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.

As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.

In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.

To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:
I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.
Within this reply, we have a problem when we think about money. Within this scenario we have a situation where the value of one thing versus another is unstable. In the case of of the house, today it might be worth 1oo,ooo pints of milk but the next day it may only be worth 99,000. Alternatively, if there is a sudden expansion in the dairy industry, it may be that the house will be worth 110,000 the next day, as there is an oversupply of milk into the market, thereby reducing the value of milk relative to other items. This can happen to any particular product, commodity or service - and that includes gold.

If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.

Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.

When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.

How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.

In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:
"Money is a matter of functions four, a medium, a measure, a standard, a store."
In all cases it is very easy to achieve the first three, but the last point is the one that causes the problem. In all cases it is impossible to guarantee the last item, even with gold. If it is a store, it must be accepted that it is potentially a leaky one. In other words, whatever is used as the standard unit of exchange, it carries with it risk that the value in exchange today and tomorrow might not be the same.

We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.

From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).

In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.

It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.

In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.

It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.

The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.

For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.

As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.

In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.

The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.

The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.

In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.

Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:
The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.
The important point in this paragraph comes in the last sentence. This is the problem that is inherent in all regulation, that there is an objective standard of assessment of risk that can be discovered and codified. The thinking behind regulation is best summarised again in the BoE paper:
One issue when deciding on the capital requirements for
each probability-of-default band is the appropriate
solvency standard that regulators should be targeting for
minimum capital.(5) This needs to balance prudence
with efficiency. Banks are regulated to protect
depositors (because of information asymmetries and the
social consequences of loss of savings) but just as
importantly to protect the financial system. This reflects
their central role in the economy. Because of their
position in the payments system and lending to small
and medium-sized businesses and retail customers, the
cost of banking crises can be very high. Bank of
England research,(6) which examines 43 crises worldwide
over the last 25 years, indicates that economic activity
forgone during the length of a banking crisis can
amount to between 15% and 20% of annual GDP.
So here we have expressed very clearly. Bank regulation is to protect depositors. What the statement does not do is explicitly state is protect them from what. What they mean when they say protect depositors is that the intention is to protect depositors from losing their money. Such an objective is impossible, as all investment carries risk, including complete loss of all capital. The only way to protect depositors is through the provision of a deposit bank (as detailed before) and even that carries the risk that the value of gold might be subject to change. The other problem highlighted is information asymmetry between depositors and the banks. Rather than address this problem, regulation seeks to address the impossible - the elimination of risk for depositors.

The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:
The 1988 Accord represented a revolutionary approach
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.
The broad categories reflected the state
of systems in banks at that time. But during the
1990s, banks started to develop more sophisticated
systems to differentiate between the riskiness of various
parts of the portfolio to improve pricing and the
allocation of economic capital. These systems
highlighted the discrepancy between required capital
and economic capital for some exposures, creating an
incentive to sell some loans. The chart below sets out a
risk measure, the value at risk (VaR) over a one-year period,(1)
for portfolios of exposures in each rating
category, and shows that for loans to all borrowers down
to BBB the Basel minimum requirements of 8% capital
(of which 4% is equity) would probably be higher than
the equity capital that a bank would chose to hold.

This disincentive for banks to hold prime-quality loans
was probably one of the factors behind the securitisation
boom in the United States. By March 1998, outstanding
non-mortgage securitisations by the ten largest US bank
holding companies amounted to around $200 billion
(more than 25% of these banks’ loans).(2) Banks outside
the United States were also increasingly turning to
securitisation to adjust their portfolios. The ability of
banks to choose how much risk they wished to carry
against a particular quantum of regulatory capital
threatened to undermine the objective of an
international capital floor. Another concern about the
Accord was that the limited recognition of risk reduction
through collateral or credit derivatives would discourage
banks from taking advantage of these techniques and
more generally impair the development of markets.
I have highlighted two sections with italics, which stand as two examples which will illustrate contradictory points. In the first section, the securitisation boom is seen to be as a result of Basel I. This was to lead to many of the problems we have seen today. The second point was actually a positive point for Basel 1, which was that it was limiting the growth of credit derivatives, which are creating ongoing problems for the banking system today, but this was seen as a negative by the BoE. Basel II sought to rectify this 'failing'. In both cases, the regulation had distorting effects on the structure of markets, and in one case a positive outcome is seen as a negative. The regulators simply can not make accurate assesment of risk.

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:
Under the standardised approach banks will slot
assets into weighting bands according to ratings from
eligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).
The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:
Exposures to borrowers without a credit rating will be
placed in an unrated band that will carry a 100%
weight (ie 8% capital charge), but regulators are
requested to review the default experience of the
particular market (and individual bank) to decide
whether this is sufficient. Undrawn facilities to
corporates of less than one year, which currently
carry a zero weight, will be weighted at 20%.
At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound. However, the institutions then game the rules, and seek ways to best exploit the rules. The only solution to this is ever more rules, and ever more complexity, and within that complexity the institutions will just find new ways to subvert the rules. Above all else, however, is the simple fact that it is not possible to remove risk from investments, and that risk must be an accepted part of any system, including risk of bankruptcy.

I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:
But, at any rate, since Basel II was not even published until June 2004, and not implemented in the US until the years after 2005 (well after the housing bubble began), how could it be a major cause of the current crisis?
Of course, Basel I (which was published in 1988 and implemented in most Western countries in 1992) could have played a role. But in the absence of the three factors discussed above (the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000, and the real estate bubble), how could Basel I have caused this on its own?
I would not suggest that Basel 1 caused the problem by itself, but rather was a contributory factor, and this can be seen in the BoE paper. The reason for the housing bubble was actually the result of a flood of capital into western markets (resultant from the shift in the world economy) with insufficient good investment opportunities to soak up the capital. Once the sound investments were gone, then there was little choice but to invest in ever more risky investments. This was compounded by the state entities of Freddie Mac and Fannie Mae having an unfair advantage in the provision of lending into prime mortgages, leaving less investment opportunities for the genuinely commercial banks. As for Basel II, it may not have caused the problems, but it certainly exacerbated the problems. In particular, putting the ratings agencies centre stage was problematic, as well as the structure for internal risk assessment.

The author of the comment, in a second comment, quotes the following:
Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence. In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!”
I would argue that this is just an example of the problem of regulation. The SEC legitimised all of this. Without such legitimacy, without the approval of a regulatory body, would this kind of practice have been so readily accepted? It is at the very heart of my argument - regulation and regulators encourage complacency. The commentator also mentioned the role of regulatory arbitrage, with the UK offering a laxer regulatory regime as a way of attracting more banking business to the UK. It is yet another example of how regulation can create distortions in the market place. The UK claimed that its 'soft touch' regulation was both sound and more efficient but, as with the US system, it was neither sound or efficient. It is possible to therefore suggest that every regulatory regime should meet the same standards of regulation, but we then encounter the Basel approach, where the risk assessment regime of both of the accords have now been shown to be wrong.

They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.

What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.

As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.

Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.

For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.

The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.

So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.

As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.

The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.

The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.

At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.

As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.

As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.

I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.

Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.

Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.


  1. Cynic.

    I'm not sure you picked the right target here, banks are way down the food chain of capitalism and thus nothing more than a tool.

    Capitalism (to me) is the ideology of the manifestation of greed in the human soul, it is the working of a philosophy that rewards and maintains the status of the rich, the entrepreneurial and the brightest of the human crop.

    I suppose you could say it's the perfect system for the richest and brightest to legitimately rob the teeming masses and keep them in their place. Having said that, capitalism supplies the goodies we all crave - capitalism is a two edged sword.

    Up to the present day, capitalism has served humans well, but life is evolving rapidly (too rapidly, we can't keep pace) capitalism has, it seems passed its sell by date and is no longer fit for purpose. In other words it is the end of the world as we have known it for generations.

    The movers and shakers of this world have been aware of this situation developing for a long time and that it would soon be with us, lesser mortal haven't a clue about anything, and further more couldn't care less as long as they can charge down the mall for their 70% off.

    We in the West now live in a post industrial world, we don't manufacture much anymore, and what is manufactured can be produced by automation so we don't need the workers anymore - hence daytime television.

    Whether sufficient wealth can be created by cutting each others hair I am not qualified to say. We are now living in uncharted territory, what used to be ain't no more, our civilisation is in crisis, we can't go forward and we can't go back.

    Interesting times.

  2. The New Capitalism Robert Preston.

    "A New Capitalism is likely to emerge from the rubble. And although it’s impossible
    to be precise about how the reconstructed economy will operate, parts of its outline
    are taking shape. What lies ahead can be determined from an understanding of what’s
    gone wrong with the existing model" more

  3. Ooops! Robert Peston.

  4. Thankyou for another well argued post. I would welcome the kind of explicit presentation of risk that you propose, but I see two obstacles to making it work.

    1) We live in a culture which does not understand risk. Thus many people buy lottery tickets with a real belief that that they stand a good chance of winning the jackpot. At the same time many people become neurotically anxious about the miniscule risks to health presented by eating certain types of food.

    2) We live in a risk-averse society which is burdened down by absurd legislation and precautions to remove risk.

  5. Mark, a very interesting post which has certainly answered some questions, and encouraged me to see a few things a bit differently.

    However, from some of the comments, I'm getting the feeling that many of this blog's readers are looking for something more radical than new variations on the free markets and banking. Even though the current financial crisis is terrifying, it is also exciting because of the possibilities for radical change, which I think is what many are looking for.

    The following article may be the sort of thing some of your readers have in mind (I saw this link in the Guardian's CIF this morning):

    'The Abolition of Work'

    I clearly remember my first day at work, and the realisation that, if I was 'lucky', I would never again enjoy more than a solid fortnight's break from it until I was 65. Now, aged 45, I think I am actually looking forward to redundancy - the probability of which is very high in the industry I'm working in. When it happens, it won't be my fault, and I won't be alone, so it will be OK. Of course I'm scared of society breaking down, and the possibility of very real hardship including lack of power, water and food, but it hasn't happened yet. If I was offered the chance to stay in the consumerist heaven of 2006 forever, I would rather take my chances with the current crash. It feels as though I am nearing the surface having been held underwater for the last two decades.

  6. Hi Everyone,

    I just found this video on google:

    The interesting part is when Frank Veneroso is talking about central banks and the gold standard.

    He says deflation is viewed as very nasty because it means lots of people can't pay their debts and creditors start to get nasty. Therefore, the gold standard was dropped so that continual inflation could be used to prevent periods of deflation.

    He says that this has worked fairly well for most of the 20th century but that it has sent out a signal over generations that debt is ok and now we are in uncharted territory because people are leveraging up and making bad decisions en-masse as a result.

    The other interesting thing was his view of how central banks perceive gold as a bygone relic.

  7. Hi Mark

    Are you intending to talk about Fractional Reserve Banking in the near future? If so, could I ask a couple of questions?

    I understand that to think of FRB as anything but a neutral, transparent means for issuing money makes one a crackpot conspiracy theorist, but I would love to know the reasons behind this. Is it correct to say that FRB cannot function unless the economy is growing? If so, does this affect government policy, such that they might be tempted to postpone an inevitable recession in the hope that "something will turn up" when, in fact, it is simply making things worse for the future? Could a means be devised for issuing money without unnecessary restriction which could cope with a shrinking economy? Or is an economy which allows recession simply not a 'capitalist' economy at all?


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