Defining the boundaries
I did a radio interview this morning, in response to a couple of stories about the second-round impacts of the government’s decision to guarantee bank deposits. Both at retail and wholesale levels, the decision has produced a rush to move funds where they can benefit from the guarantee. Those at the losing end, including foreign investment banks and mortgage funds are, unsurprisingly, upset.
This process was in fact underway before the announcement of an explicit guarantee, though the main trend was from smaller banks to the “too big to fail” Big Four. The guarantee benefitted the small banks, but put the pressure onto nonbanks and foreign banks. This was more or less inevitable and raises the question of the next steps.
Two responses are necessary. First, the government has to define the boundaries of its guarantee, making it clear that any investment outside the guarantee will not be bailed out under any circumstances. Second, it has to make it clear that there is a significant price to be paid for the guarantee. The price will include both an insurance premium and restrictions on risk-taking.
In the long run, this should lead to the kind of narrow banking model I’ve long advocated, in which publicly guaranteed banks stick to a tightly regulated range of well understood activities. This allows for a completely separate set of financial institutions, of which stock markets are the exemplar, where government guarantees are ruled out in advance*. These would offer higher returns but no possibility of transferring risk to the public.
The ultimate losers from the process are likely to be the Big Four, which previously got the benefit of “too big to fail” status at zero costs.
* It’s probably impossible to preclude emergency rescues of firms seen as vital, like Chrysler in the US or Rolls-Royce in the UK. But, where such rescues are unavoidable, they should be done on terms that wipe out the great bulk of shareholder equity and require a substantial haircut for bondholders as well.