Banking Crisis

I had a front row seat in the 1974/75 banking crisis.  It was hair-raising but nothing like as serious as 2008.  In 1974, NatWest was the only major UK bank to be in jeopardy.  Today, the problem is global and the banks that were not in danger recently are few and far between.

Ten days ago Mervyn King said that you could almost write the script for the next banking crisis while there were banks that were ‘too important to fail’, which could engage in risky activities knowing they would be bailed out by governments.

The extreme vulnerability and fragility of banks due to the leverage in today’s market instruments was clearly flagged in 1995.  The City’s oldest merchant bank, Barings, was brought to its knees by a 28 year old trader, Nick Leeson, who made a loss of £827m, enough to put them out of business.

There were several minor frauds of a similar nature during the next few years but it was not until 2007 that Nick Leeson was out-shone by 31 year old Jerome Kerveil.  Societe Generale in France was crippled by his trading losses of an astonishing €4.9bn!

In both cases it can be argued that the two traders were trying to make profits for their banks but when they turned into heavy losses they got out of control.  The trouble with futures trading and other forms or proprietary trading is that they can be very highly leveraged, an easy prey to dishonesty and very subject to human error.  For example, after a heavy drinking session the night before, a trader would only have to mistakenly put an extra zero on a transaction and his bank would be committed to ten times the figure he had in mind.

A further problem in recent years is the increasing complexity of derivatives, some of which are becoming so exotic that they are very difficult to understand.  It is no wonder that the directors of many of our banks do not have the faintest idea of what they are all about and the risks that are being taken by their traders.

The Governor warned that urgent steps should be taken to rebuild the Glass-Steagell firewall between commercial banks that take deposits and investment banks that engage in risky projects including speculative futures trading.  I believe that he has never said a truer word.

The bank bonuses scandal highlights the ridiculousness of the present position.  Traders are being rewarded massively for taking massive risks.  If they fail miserably they do not share in the losses, they just do not get their bonuses.  Meanwhile their bank may have become insolvent as a result and taxpayers’ money would have to be put in to save it.

Old-style commercial banking should be a very good business.  Much stronger regulations could be put in place to limit property loans in relation to security and earning cover.  There is no need for the 125% Northern Rock style mortgages and there is certainly no need for the banks to gamble on futures with, in the last analysis, taxpayers’ money.

Equally, well-controlled investment banks could be very successful businesses.  If they did well their shareholders would benefit and management would receive substantial bonuses.  If they failed shareholders would lose their money with no hope of a bail-out and management would lose their jobs as well as their bonuses.  Hopefully management would then find it more difficult to find another investment bank to ruin.

Critics of Mervyn King will say that he is over-simplifying the problem but at least his proposal would be a big step towards hiving off the most dangerous parts of the major banks.  It would also result in those speculative parts not being ‘too important to fail’.  You have to start somewhere unless you want it to happen again.

Jim Slater