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Will the US President sink the bull market? - John Redwood Comment

January 26, 2010

Markets nosedived on Mr Obama’s call to arms against Wall Street. Investors feared his threat of regulation and bank splitting could damage bank profits and the wider economy.

The President’s wish to split off hedge funds, proprietary trading and venture capital from utility banking on the High Street could be done. If he just tries to do it in one country, even a large and powerful country like the USA, the mega banks will simply shift their ownership of these areas elsewhere. If the US claims extraterritorial jurisdiction, then the mega banks based in the US could switch their HQs to another overseas territory. If he still pursues them, they could split their capital structures.

If all the main banking jurisdictions of the world agree some new Basel accord on the subject it is likely the big banks would get the message. They could sell off their private equity, trading and hedge fund arms as separate companies. They could split themselves into investment banks containing the “naughty” business as defined by the President, and utility banks.

All this implies two things that I do not agree with. The first is, it suggests the three specified areas were the ones that caused the problems, whereas in many cases this is not true. Secondly it implies that future bailouts of utility banks is acceptable. Surely we ought to be seeking a world where bailouts are not needed? Why does the taxpayer have to face more pain for banking incompetence and Central Bank error?

What we ought to be discussing is how to regulate cash and capital by banks in a way which makes failure less likely. We need to discuss why the main Central Banks got it so wrong, why they kept interest rates too low for too long to create the bubble, then held them too high for too long to create the slump. We need to understand they ran a boom and bust policy, and both phases were wrong. We need to find people to run the Central Banks who don’t drive by looking in the rear view mirror, but who can think ahead.

If we stick with the regulation of commercial banks, the Regulator could make it clear their guarantees only extended to the utility bank subsidiary in their jurisdiction. If each national utility bank was separately accounted it could remain solvent and independent if the rest of the Group went down. Alternatively, we could just strengthen deposit insurance so all who we wish to protect in a crash have the reassurance that their money is safe. Under either of these models there is no need for a run on the bank to add to its other troubles.

In the UK we need to split up RBS and Lloyds whilst they still have large public stakes. If the minority shareholders do not like it then they must arrange for buyers to take all the government’s shares at a profit for the taxpayer to allow them to call the shots. We need to strengthen our competition policy, by explaining to our Competition authority that the aim of policy is to get much more competition into High Street banking in the UK, supporting the policy of splitting RBS and Lloyds.

There is still a need to regulate cash and capital. It is true there is no evidence from the recent past that the Regulators knew how to do it. We should try again. All banks and financial businesses taking positions on their balance sheets and offering to pay people their money back at some point in the future should be expected to keep minimum levels of cash and capital. These levels should normally be higher than they were in 2007. In the short term they should be lower, as we need to generate more loans and financial activity to help the recovery.

Sometime we need to come off quantitative easing and very low official interest rates. This is just a money go round to let the government spend too much, and to allow the banks to earn easy money. It does not help the rest of the economy, still struggling with too little credit at too high a price as a result.

For Mr Obama, it was bash or be bashed.

The US public – like the UK public – were not happy that so much of their money was tossed into propping up banks, or put at risk underwriting them. They became livid when those same banks, a year later, were busy paying their top executives mega bucks in bonuses as if nothing had gone wrong, as if they had earned the money by their own great talents.

Mr Obama has just had a very bruising encounter with the US electors. Both the winning and losing candidates in Massachusetts stated that the big issue was Obama’s very own unpopular health care plan. Mr Obama says he is quietly parking or delaying the offending big idea. Now he needs to change the topic and find people and institutions more unpopular than himself. Enter the bankers.

Like many modern politicians Mr Obama is good at moods and sound bites. He ought to be, as no doubt they spend a fortune tapping the mood and polling the words. So far he has found it more difficult when it comes to executive action, unable to develop honed policy and put it through. Closing Guantanamo was a great sound bite, but a year on it hasn’t happened. Changing the approach to the Middle East with a new kind of foreign policy sounded good, but the intensified Afghan war looks more like Bush mark two. Offering healthcare to those who could not afford it sounded heroic. Instead many Middle Americans feel threatened with higher cost health care and higher taxes.

So what is Mr Obama offering for his new banking policy? We do not know. There were two short paragraphs, designed to send a single message – he welcomes a fight with Wall Street. It worked with the tabloids, but it is scarcely a considered policy towards banking regulation.

He also implied that some banks were too big, without defining how big a bank should be and without naming the ones he had in mind. He wants big banks to get out of various activities.

If he had bothered to think about the crisis we have lived through, he would have noticed that the two biggest catastrophes in the US were Freddie and Fannie. These are both specialist mortgage banks, brought down by advancing too much mortgage to too many people. His remedies do not tackle that issue. He might have spotted that Lehmans went bust. That was a specialist investment bank, that would also be unaffected by his two paragraphs. If he had looked across to the UK he would have seen that Northern Rock, Alliance and Leicester and Bradford and Bingley were also all specialist mortgage banks.

Out of his sound bites could come a sensible policy. As readers will know, I do want the two UK state owned mega banks broken up. They were too big to fail and too big to bail. The breakup of banks that needed taxpayer support and might need it in the future is a good idea. Ensuring that in future they have more capital at the dangerous stages of the cycle would also be a good idea.

Markets should not worry too much about these rash statements from the President. They were more political than considered policy. It would be surprising if the US rushed into tough regulation before finding out what the rest of the world will do. The Sarbanes Oxley Act  handed large areas of financial business on a plate to London. I doubt London will be so lucky this time round.

Regards,
Evercore Pan-Asset Team