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Top down design is flawed even in finance

The Times published my op-ed on banking reform:

It is not yet clear whether the current rage against the banks
will do more harm than good: whether we are about to throw the baby
of banking as a vital utility out with the bathwater of banking as
a wasteful casino. But what is clear is that the current mood of
Bankerdämmerung is an opportunity as well as a danger. The fact
that so many people agree that some kind of drastic reform is
needed, all the way along a spectrum from Milibands to mega-Tories,
might just open the window through which far-reaching reform of the
financial system enters.

All the actors involved bear some blame. First, investment
bankers and the principals in financial companies that cluster
around them have trousered an increasing share of the returns from
the financial markets, leaving less for their customers and
shareholders, while getting “too big to fail”, so passing their
risks to taxpayers.

Second, regulation has failed. As Niall Ferguson argued in his
recent Reith Lectures, the perverse consequences of bad regulation
bear more responsibility than deregulation, especially given the
lack of banking trouble in lightly regulated Australia and Canada.
With a Financial Services Authority handbook that runs to 6,000
pages of rules, evidence of rampant deregulation is hard to

Examples of bad regulation are legion: the easily gamed Basle
capital rules; the US Congressional mandates that virtually forced
mortgage lenders to increase lending to those who could least
afford loans; the hyper-regulation of British customers in the name
of preventing money laundering, making it far harder to move your
account, in stark contrast to the minimal regulation of the cosy
Libor-setting cartel (or “cesspit” as the Bank of England’s Paul
Tucker called it).

Third, central banks have failed. What we might call the
Greenspan- King doctrine – that central banks should intervene by
cutting interest rates if asset prices fall, but not if they rise
thanks to cheap money fuelled by a deliberately undervalued Chinese
currency – was merely the latest example of central banks actively,
if unwittingly, encouraging volatility.

Enough diagnosis. What is the cure? A change of personnel will
not do it. The search for chief executives who are not motivated by
greed and for regulators who are sufficiently god-like to know how
to design rules that cannot be gamed will never succeed. The truth
is, the financial system, like the whole of human society, was not
designed in the first place; it evolved. And the answer is to allow
a better one to evolve.

My own personal experience reinforces my view here, as I was
chairman of Northern Rock when it ran into trouble. During that
crisis it quickly became clear that not only did I not fully
appreciate the liquidity risks in the markets but nor did far more
expert people, including rivals and regulators.

That experience, plus some appreciation of evolutionary biology,
makes me suspicious of utopian solutions. Regulating Libor will not
prevent a scandal somewhere else; reinventing Glass-Steagall’s
separation of retail and investment banking would not have
prevented the failure of Lehmans or AIG; paying executives in
shares rather than cash to lengthen their horizons has been tried
and it failed; a culture of compliance can become lethally

What we need is an evolved, organic, bottom-up system that hands
power back to customers and gets innovation working on potential
improvements. The way to get that is to open up the banking sector
to plentiful competition, dismantling its cosy, crony oligopolistic
structure – in which, for example, the biggest customer, the
Government, hands the bigger firms handsome income streams from the
taxpayer for bond issuance.

So the first task is to tear down the barriers to entry that
have prevented the emergence of new clearing banks for decades.
Make it much easier not just for the supermarkets’ new banks but
for mobile phone companies to set up financial services systems as
they have so successfully in Africa where few people are trapped in
conventional banks. Make it easier for customers to move between
banks. Punish size – make regulation fall more heavily, not more
lightly, on the biggest companies. And break up the state-owned
banks into small units before selling them. Innovation would then

In the future we could open up the world of currencies so that
you are neither limited to using pounds nor even to traditional
forms of money. Transactions could be in synthetic digital
currencies such as mobile phone credits (already big business in
Africa) or something yet unheard of. Such ideas about competition
between currencies should be encouraged, not stomped on by a
jealous state monopoly.

The one politician who is thinking hardest in this way is a
radical Tory MP, Douglas Carswell. He points out that Germany has
2,000 banks, most of which are utilities serving local businesses,
not casinos serving gamblers. There is nothing inevitable about the
concentration of banking into a stodgy oligopoly of banks as in
this country – a concentration that has only grown as a result of
the crisis, since Barclays now owns Lehmans, Lloyds owns HBOS and
Bank of America owns Merrill Lynch.

Mr Carswell would reinvent Glass-Steagall’s distinction between
investment and retail banking but horizontally within banks rather
than vertically between them. Under his system, when you deposit a
sum at the bank you would tick one of two boxes. Box 1 would mean
the money remains yours and the bank just stores it for you,
safely, and probably for a fee.

Box 2 would mean the money would be lent on by the bank in the
normal “fractional-reserve” way, with the promise of interest. Only
Box 1 money would attract a deposit guarantee from the State.

Who knows how much money each box would attract? The traditional
divisions of banks would have to sharpen their act to attract
customers. And any institution that could not convince many people
to risk their money in this way would automatically have a higher
capital ratio. No need for an artificial calculation.

As Adam Smith and Charles Darwin showed, you cannot plan an
economy or predetermine innovation any more than Mother Nature can
design an ecosystem or a giraffe. These things evolve. So banking
reform must concentrate on finding a mechanism to put trial and
error to work, not on defining a perfect system that only works
with angels in post.

By Matt Ridley | Tagged:  rational-optimist  the-times