Seat Belts, Cycle Helmets and Bank Regulation

A couple of years ago I saw a study that looked at whether wearing a helmet while cycling reduced a cyclist’s chances of being killed in an accident while on their bike.

As I recall it did but there were two competing factors. The obvious one was that helmetted cyclists who suffered an impact to their heads were less likely to experience a serious injury than their bare-crowned colleagues. The other was that cyclists who wore helmets seemed to be more likely to have an accident – the theory being that putting a helmet on made the cyclists less worried about potential injury and less likely to cycle as carefully.

Whether or not that is the case, it doesn’t sound implausible. If I were driving a big, modern 4×4 with modern seat belts, airbags, side impact bars, crumple zones etc. I might well drive differently than if I were driving a rickety, 1960s rust bucket with no seat belts, no airbags and a massive spike poking out of the steering wheel, ready to impale me in the event of the slightest impact.

While adding safety features is welcome we should not discard the flip-side of the coin that attitudes could become less risk-averse as a consequence. People might well believe that the problem is solved to a much higher degree than it really is and therefore discard a risk that previously they took very seriously.

At the moment the government is looking closely into proposals by the banking commission that would bring new regulative and punitive measures to our banks. These include things like spreading bankers’ bonuses over a period of up to 10 years, and putting them in prison if they are “reckless”.

While I welcome proposals that might help to ensure a safer banking system, I don’t think either of these achieves an awful lot to prevent a future financial crisis. The primary problem that we need to address is not whether we can put a banker in prison if they bring down a bank and not whether a banker receives £1m today or £100k per year for the next 10 years.

The primary problem is that almost five years after Lehman, we still have no way to let a major bank go bust without taking down the global economy. As I said, new ideas for how to better regulate banks are welcome but irrespective of what they are, we should be in no doubt that the banks of the future will always find new and more exciting ways to go bust. Faith in the idea that we can make regulations to avoid this scenario is misplaced. A much more useful area on which to focus our attention would be a reform of the banking system in such a way that a bank is never “too big to fail” and if the worst happens and a bank does go bust, the world economy is left intact afterwards.

That is not what these proposals are addressing though and my major concern is not just that they might well be far less effective than the government thinks; it’s that if we implement them, we’ll relax, and (with our cycle helmet and seat belt in place), pat ourselves on the back and think we have truly solved the problem. We won’t have though. A bank, irrespective of regulation, will always be able to go bust. If we are going to learn just one thing about the causes of the financial crisis it should surely be this and it would be really nice if we properly addressed that problem now.

The alternative is that we wait for the next financial crisis to convince us.



Banks, Bishops and Robin Hood

Suppose you have £100 in your pocket. You know at some stage you are probably going to need to use it to pay for something but not today. Maybe tomorrow but not today, so you lend it to a bank for a day and they pay you some interest and tomorrow you get back £100.02.

The next day again you don’t need your money so you lend your £100.02 back to the bank and the day after you get £100.04. You continue doing this every day making a daily 2p profit until a month later the day comes when something crops up and you need to use your £100. In that period, because you invested you have made a 60p profit compared with having just kept the £100 in your pocket.

That’s all nice and easy. Now suppose that the taxwoman comes along and every time you transact with your bank she charges you 1p.

(Why do people always assume that a person working for the IRS is a taxman? This time it is a taxwoman – I am fighting for equal opportunities.)

With this tax in place it is still profitable to do the investment but your profit is reduced to 30p, having reinvested your money every day for 30 days and having been charged 1p each time.

If you are feeling a bit miffed at losing half of your profit there is an alternative. Rather than invest your money for one day 30 times in a row, you could invest it once for 30 days. Since you are now doing just one transaction instead of 30 you will pay just 1p to the taxwoman and walk off with a healthy 59p profit. Hoorah! Take that you thieving taxwoman!

There is a downside though. The nice thing about the first option was that each day you got your money back. If you needed it to pay an unexpected bill you could do so and if nothing unexpected came up you could just reinvest and have the same choice again tomorrow. By moving to the single 30 day investment you have in fact made a bet. You have bet that at no time in the next 30 days will you need to access that cash.* If after 20 days you do have an unexpected bill to pay then you’re in trouble.

In effect, what the taxwoman has done, in trying to raise revenue, is unwittingly made you take a risk. Having easy access to your money was very expensive compared with not having any access to it for a month. You thought it was worth the gamble.

Of course, the profit of 30p or 59p is unlikely to make anyone bother to invest at all but scale this up to the amount of excess cash a bank might have on a particular day, which could be tens of millions of pounds and suddenly the difference between the two options becomes something to think about. Should they invest it daily knowing that they’ll get it back the next day should they need it but making a small profit or should they invest it longer term knowing they’ll make a bigger profit but might be in a pickle if they need it unexpectedly?

Irrespective of what they decide, the taxwoman has given them a new incentive to take a risk.

This week the Archbishop of Canterbury came out firmly in favour of such a tax. He is backing a tax on financial transactions known as the Tobin Tax (after American economist James Tobin who first proposed the idea back in 1972).

While I think taking economic advice from a clergyman almost as absurd as taking it from a politician, I do see why the Tobin Tax, (recently rebranded in the UK as the Robin Hood Tax) has gained popularity. These are some of the things I have heard about it:

  • The tax is a good idea because it would stop banks taking risks
  • The tax is a good idea because it is only tiny in the grand scheme of things and it would still raise lots of money
  • The tax is a good idea because the banks caused the mess so they should pay to clean it up

I’ll take each of these in turn.

It would stop banks taking risks

As I showed in my simple example of investing spare cash (traditionally a low risk activity) this tax gives an incentive to move from a safer strategy to a more risky one. It is simple enough to see in this example but apply it to the complex things traded between banks (which 2008 showed us even they don’t understand) and we really don’t know what effect it would have on the market in terms of risk. It would most likely lead to fewer, bigger, longer term transactions and those are simply more risky not less.

The tax is tiny and will raise lots of money

That doesn’t make sense – they can’t both be true. Rowan Williams thinks the tax could raise $400bn each year. According to this McKinsey report, global banking profits last year were $712bn. Are we honestly saying this is a small tax that the banks won’t notice? That’s over half their profit!

Will it raise lots of money? Probably but remember, banks are experts in passing on the costs of something on to their customers. If you want to borrow some money when such a tax is in place, what is to stop the bank just giving you a worse rate to compensate? In doing so it isn’t the bank paying the tax, it’s you.

Banks caused the mess so they should pay to clean it up

The banks did cause the mess and they should pay towards the clean up. If you think that such a tax is going to recoup what they cost us though, think again. I would broadly estimate that the total cost of the problems caused by the banks will have a negative effect on the UK economy alone to the tune of several trillion pounds. Sorry, that’s never coming back.

Also, just because the banks should pay towards the clean-up doesn’t make the Tobin Tax a good way of doing it. If we decide to go after the banks a simpler way of doing it would just be to tax their profits. If we did that at least we wouldn’t push them towards risky trading strategies even if they would still probably try to pass the extra costs on to us.

You can therefore summarise from this that I don’t think it’s a particularly good idea. Please don’t misunderstand me – I would love to get some money back off the banks. I just can’t see this is a good way of doing it. Branding it The Robin Hood tax was a stroke of genius – take from the rich and give to the poor etc. It gives the tax a certain romantic quality and I think that’s where a lot of its political support comes from.

Sadly though, a tax is a tax and romance can play no part in differentiating a sensible one from a bad one.


*Additionally, putting money on deposit for a longer term opens the lender up to increased credit risk as if the borrower gets into difficulty during the period the lender can’t just decide to get their money back and reinvest elsewhere.

P.S. As with all of my posts this is purely my opinion and I’m not saying that my opinion is definitely correct or any better than anyone else’s. As always, whether you agree or disagree with me, I am happy to hear your thoughts.

Blame it on the Bonus?

It seems to me that politicians are very keen on blaming the recent financial crisis on the bankers who earn big bonuses.

I rather think it is a little more complicated than that but before I stray too far into why, I’ll give a basic example of why a trader may tempted to take a risk.

I recently found out that Scottish Power have overcharged me on my direct debit by so much for so long that they owe me £1,000 and have to send me a cheque. I could invest this in a savings account with a high street bank. I may get an interest rate of 1% on such a deposit, meaning in 1 year’s time I will have £1,010. The £10 I have made doesn’t really set my world on fire (especially when taking inflation into consideration I will have made a loss) but the upside is my money is safe. It is so safe that it is even guaranteed by the UK government in the event of the bank going bust.

Alternatively I could invest my £1,000 in the stock market. The stock market is much less predictable – my money in a year’s time could easily be £1,250. It could easily be £800. If things went really badly for the company I invested in it could be worth £0. In fact I have very little idea about how much it is going to be worth but returns in the stock market historically outperform returns on a bank account so I may be tempted by the risk.

This is also the reason why a trader takes risks in a bank. Simply, risky investments are more likely to yield a larger return. If there were a risky investment which had a likely lower return than a safe investment no one would bother going near it. Therefore we can say that when a trader takes a risk they think it is more likely to yield a larger reward than the safer option.

Now let’s extend this principle to Evelyn. Evelyn is an evil, heartless trader who, when she isn’t out running over old ladies in her Ferrari, has a bonus scheme which pays her according to the profit she makes for the bank. If she put all of her available funds into a safe bank account she’s going to get no bonus – anyone could have done that. In order for her to get the new Lamborghini she’s got her eye on she is going to have to take some risks.

Evelyn has taken risks with the money for the last few years and every year the risks have worked out and she has made a fortune for the bank and a fortune for herself. Until 2008. In 2008 everything didn’t work out and she lost 100 fortunes for the bank. The bank couldn’t foot the bill and the tax payer had to bail it out. Therefore Evelyn caused the financial crisis.

It was all Evelyn! Case closed, right? Wrong. Who spotted the real problem in the above paragraph?

“…and the tax payer had to bail it out.”

It may not seem immediately obvious but Evelyn hasn’t actually done anything wrong in all of this. All she has done is respond to her incentives. She knows the riskier the strategy the more chance she has of making the big bucks. The smallest her bonus can be is zero – if her strategy doesn’t come off it’s not like she has to fund the loss herself. She has simply responded to the incentives the bank gave her.

In a bank as well as the traders, they have people called risk managers. Risk managers are responsible for determining what traders are allowed to invest in and how much they are allowed to invest in it. They do lots of complicated maths and put in place policies to police the traders. If I were going to start pointing fingers at bank employees I would probably have a good look at them before the traders. I’m not though.

Recently @WH1SKS, (one of the greatest people on Twitter, follow him) said he thought that the banks didn’t seem to have really paid for their failure, although everyone else did seem to be paying for it. He was completely right.

Banks, you see, are “too big to fail.”

“Too big to fail.” It drives me nuts. Outside the financial sector you will find no one “too big to fail” and you will find no one who could possibly fail in such a big way as they have.

I work in a small company. If we made enough bad decisions we could probably make ourselves go bust. At that point we could go to the chancellor and ask for a bailout but we won’t get one because outside our staff and our clients no one gives a stuff whether we’re there or not. Our company therefore has a massive incentive not to take unnecessary risks – a bunch of risky strategies could be the end of us. A risky strategy for a bank now means either a massive profit or, if it all goes tits up, a handout to keep it going. The bank is now no different to Evelyn – in the good years make a bundle and in the bad ones know your maximum downside is you keep going anyway and someone else pays for it.

The banks could not be allowed to go bust because the impact on the global economy would have been far worse than it was to bail them out. They each had so much in the way of liabilities that them going bust would not only have taken out the finances of many individuals and companies, it would also have taken out other banks and the whole thing would have gone down like dominoes.

So what’s changed? If RBS tomorrow were to announce they were in a pickle they’d get bailed out again because the same problem is true today. If the banks were too big to fail before, it’s even worse now because due to the mergers which followed the financial crisis, they are bigger now than they were before.

All this has proved is that it is a completely unworkable system to have organisations which cannot be allowed to go bust when they make bad enough decisions. If that is the case, they have no incentive to abandon risky strategies and they will continually need to be bailed out when the strategies don’t come off.

So what’s the solution? There are several contenders. Perhaps banks should have to provide the impact of their potential bankruptcy as part of their financial reporting and auditors should have to verify they could go bust without causing financial meltdown and if they can’t prove it they would be broken up. Perhaps they just need to hold more capital? Perhaps there should be legislation forcing them to raise more money through equity rather than debt?

It’s a debate that needs to happen because it is a problem that must be solved and has not been solved. By bailing them out all we have done is put an Elastoplast over the underlying problem. There are still financial behemoths out there with incentive to take risks and nothing to guarantee it won’t result in a bailout. I don’t know the full solution, but I do know one thing:

If a bank is too big to fail – it’s too big.