To reduce banks' risks, profits have to shrink
The fact is illustrated in the graphic. Banks had an extreme profits bubble in the years before the credit crisis. (European banks are in the chart; US banks would look similar.)
How could earnings take wing like this? Basic financial theory makes clear: to make returns so much greater than former norms, they must have taken on far greater risks.
We know what happened in 2008. Banks' risk must, therefore, be reduced. That means, of necessity, that banks' profit will be lower than they were during the mad years of the credit boom. Reducing banks' profits is not an end in itself and has nothing to do with ideology or revenge. It is simply a necessary byproduct of a move to reduce risk.
Now for the oft-forgotten principle: bank runs are lethal. They must be prevented at all costs.
This sounds almost quaint. Even after the UK's Northern Rock bank run in the autumn of 2007, they seem like something out of Charles Dickens, or It's A Wonderful Life.
But bank runs - which cause banks to collapse when customers all take out their deposits at once - have been endemic through much of history. It was widespread banking collapses in the early 1930s that turned a severe downturn into the Great Depression. That, in turn, convinced US politicians, with others following their lead, that depositors must be protected. Rather than using the threat of a bank run to discipline banks, US regulators introduced deposit insurance.
The result was what the Yale academic Gary Gorton calls a "quiet period" of many decades without a bank run. Historically anomalous, it overlapped with a period of steady growth. But Depression-era regulations were steadily removed, while banks found ways round the rules that remained.
Once this process was complete, banks enjoyed the risk binge shown in the chart - and then nearly collapsed. That collapse was driven by a bank run. It was not the Lehman Brothers bankruptcy itself that brought markets to the brink of disaster, but the fact that two days later a large money market fund, perceived as being as safe as a bank but without deposit insurance, took a loss on Lehman bonds.
Money market funds had grown up as a way around deposit insurance and thus offered higher rates than banks. The news that they could lose money led to a stampede by investors.
In the ensuing months, government worked on the assumption that the collapse of a large retail bank must not be allowed. Huge sums were devoted to keeping afloat large universal banks, which combined the investment and retail banking. If the ATMs of a large bank had ever stopped working, the crisis could have tipped into a far more dangerous phase.
How does all this relate to the current debate? In the US, the Volcker rule - named after Paul Volcker, the former Federal Reserve chief who evidently still resents and regrets that the way regulations were chipped away under his watch - will force deposit-taking banks to give up proprietary trading. This is about protecting depositors and averting bank runs.
It would make banks less profitable. That is a shame. Banks needs to build their profits to make themselves less risky. But it is unavoidable and is no reason to avoid reforms. And yet the Volcker rule is at the centre of a firestorm of criticism. US banks are outraged, as are foreign politicians, whose banks could be affected.
It is important to get the detail right, but what is needed is a good-faith effort to ensure that the Volcker rule that emerges succeeds in safeguarding depositors. Everything else is secondary.
In the UK, bonuses are back in the line of fire, along with the losses of the two wards of the British state, Loyds Banking Group and RBS. Both needed bail-outs to survive and both are dogged by a legacy of unwise risk-taking. But it is unclear why bonuses matter. Envy and revenge are natural human emotions, but have nothing to do with creating a safer banking system.
Bankers' pay is a subsidiary issue, a symptom rather than a cause. It will tend to fall as bank profits come down. Competitive dynamics within the industry put a limit on how much they can prudently be cut, even by a lossmaking bank. And for those traders whose performance can be easily benchmarked by their profits and losses each year, "bonus" is a misnomer. They are being paid for results.
Taking the long view, the project of de-risking the banking system is vital. It means that banks and bankers will make less money than they did in the boom years. This makes for a slower economy and it means that RBS and Lloyds will be greater burden on the UK taxpayer for longer. But it is unavoidable. Neither bankers' special pleading nor populist outrage, should obscure this. from FT.
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