Banking Reform

Once we have banks that have been re-capitalised and apparently stable once more, where does our financial system go? In negative terms, how can we be assured that the financial system will not generate crises on the kind of scale that we are currently living through? In positive terms, how can we increase the chances that finance flows toward productive rather than speculative uses?

These critical questions are largely sidelined in the current debates on nationalization, which have focused largely on the (urgent and very important) questions of how to restore the stability of the banking system and who will end up stuck with the bill. But, even if this is achieved at the least possible cost to the taxpayer (and therefore with the least possible constraint on public investment into the future), this still leaves the questions of stability and productive investment. There is little reason to suppose that an unreconstructed banking system will deliver this on its own – the banking system provided neither stability nor productive investment before this crisis. Reform of banks themselves will be essential, although this has largely disappeared off the agenda in recent months.

There are five areas through which we can influence how banking practices are shaped by the wider system of financial governance (some of these are usefully reviewed in Stiglitz and Uy’s account of the ‘East Asian Miracle’). In each area, the system has left a great deal to be desired and requires reform.

First, we can change investment incentives. When capital gains tax was cut to 20% in 1998, capital flowed into the economy. But as is well known, the vast bulk of that capital went straight into property and, to a lesser extent, financial speculation. Even if capital gains had been reduced selectively, the gains from investment could have been channeled into more productive areas like R&D. As it was, the exceptionally low tax rate combined with various schemes promoting property investments channeled financing away from high tech and other export sectors just when many of them needed that financing most to build international scale operations. There are glimmers of hope in recent government documents of a recognition for the need for a re-design of the incentives for investment, with talk of supports for R&D and education. There are also depressing signs of a strong persistence of business as usual – many millions to go into banking with little reform attached, six million in subsidized pension loans to go into construction, while a one billion euro plan to protect jobs and boost skills proves difficult to approve.

Second, we can regulate the provision of private sector credit. Government plays a crucial role in providing a framework that promotes liquidity in credit markets. However, it is also clear that government must be involved in ensuring that this liquidity maintains a link to the real economy. This does not require that strict capital controls or similar measures necessarily be imposed but it does require a managing of the openness to the more loosely regulated parts of financial markets. Rules about capital requirements, about particular kinds of financial instruments, about dubious transnational capital flows, and about reporting standards will be necessary components, among others.

This is also a matter of the regulator providing a counter-balance to the ‘social milieu’ and analytical models of financial analysts that produced a massive discounting of the risks of the financialised economy. Regulators must provide the institutionalized prudence that can control the ‘irrational exuberance’ of financial markets.

Third, there is an urgent need for an enhanced role for the state in channeling credit to business. It has already been playing a central role in that respect. The state agencies have been a significant funding agency for high tech firms, have led the building of a venture capital industry and have made effective investments. On the other hand, these investments fall well behind the scale of the investments in promising firms made by other countries – including the apparently ‘non-interventionist’ US where an increasing number of the best technological innovations come from federal labs, federally funded R&D and networks of firms supported through government schemes (Block and Keller, 2008). As Iona Technologies founder Chris Horn argued in the Irish Times recently, these kinds of supports need to be extended significantly (with all the safeguards that are by now well developed in Enterprise Ireland and elsewhere). In short, we don’t have to invent a public industrial development bank – we have one already in place that needs much greater funding and political support.

Fourth, we need to transform the organisational culture and capabilities of banks. One of the most remarkable elements of the banking crisis is what it has revealed to public scrutiny about the internal culture and capabilities of the banks. The banks have simply got a very weak capability as organizations to make productive investments. For many years now, the only serious investment options they offered to private citizens was the savings account or buying property abroad. There may well be some human capital problems with temporary nationalisation – but there is certainly an issue with the skills and practices inside the banks themselves.

A temporary nationalization of the banking system will not in and of itself transform this culture and capabilities but it offers an opportunity to do so. The recent ‘swap’ of expertise between Enterprise Ireland and the banks suggests precisely such an effort – but the resistance by government to nationalization suggests a lack of a broader willingness to take on this issue. Indeed, it will most likely take a sustained effort to do so since the partial zombification of the banks at present is hardly conducive to organizational re-invigoration. A period of nationalization should result in organizational restructuring as well as financial stabilization.

The fifth area of reform is the area of regulation itself. If the state must play an enhanced role in governing finance, then the question of how the regulatory system itself is organized is crucial. The model of regulatory independence has been shown to be flawed. Many serious questions have been raised about the Financial Regulator and many of the solutions proposed have focused on the kinds of people to be recruited to lead the agency. However, more serious changes are required. The insulation of the ‘independent’ regulator from the broader democratic system appears only to have encouraged ‘regulatory capture’ by industry interests as the regulator operated outside the view of the democratic system.

The regulator needs to be able to engage with the industry and MIT research has shown that conversations between industry and regulators has been an important source of learning for technology firms in the US (Lester and Piore, 2004). But there needs to be a counter-weight against the pressures of capture that are generated through these dialogues between regulator and regulated. Putting increased pressures of external accountability on the Financial Regulator would guard against the kind of apparent ‘capture’ that have occurred in recent years.

A much stronger role for the committees of Dáil Éireann in reviewing the financial sector on an ongoing basis would provide such a forum. Protection for auditors and whistleblowers would also seem essential, given the pressures that were evidently put on auditors in the recent past. Ironically, they would therefore allow the Regulator to engage in properly advising the banks, knowing that these stronger structures of external accountability were in place. Greater democratic accountability will only strengthen the capacities of the regulator to monitor developments in the sector.

One of the effects of the current crisis has been to push issues of economic governance and policy into the public sphere. Much more complex public discussions regarding the economy and financial sectors have taken place in recent months than over the past decades. This serves to show up the weakness of our ‘economic democracy’ in normal times. Governing our financial system to provide stability and productive investment and democratizing our structures of regulation will be essential elements in enhancing both our economic and political life. We should not let debates over NAMA, important though they are, distract us from these vital regulatory issues.

4 replies on “Banking Reform”

A thoughtful and well-argued contribution.

One major reform objective that you did not mention should be ensuring that these necessary changes do not stifle innovation in the economy. Although the more heavily-regulated continental economies did much better in the current financial crisis, over recent decades they have fallen behind (and played innovation catch-up) in terms of entrepreneurial activities. That is the potential downside of the more tightly regulated system that you describe. However much of what you say is quite convincing despite this concern.

I am concerned that anyone could even think about any type of ‘reform’ of the existing retail and savings-and-loan financials in this country. They are insolvent (most, though not all) and should go into administration. The legislature has no right to beggar existing and many future taxpayers with the debts of private companies, operating in ‘the market’. It is quite disgraceful and, to slightly misquote the late John Healy – ‘None of you are shouting STOP!’ Why? Are you fearful? Are you just ignorant? What is it that is preventing you from shouting STOP? Do you honestly, and genuinely, recognize that the financial burden that will be placed on future taxpayers cannot be paid down absent a continual, incremental increase in economic activity? So what is this ‘growth’ to consist of? Inflation is my guess. Do you have an alternative suggestion?

The existing financials in this country have gone insolvent due to heroic levels of Skilled Incompetence allied with the insufferable arrogance of their senior managements (possibly abetted by some directors). Reform!!! Sheer madness. Bankrupt them and be done with it. The State can constitute three new financials to replace the existing rubbish. These new financials would be free of debt – and little burden on the taxpayer. Please start shouting STOP before it is too late to prevent a dreadful economic and social calamity on this country.

Before you formulate your response to my question of ‘what growth’, please consider, carefully and diligently, how we attain growth – what do we consume to provide this growth? Next consider East Asia. Is there a large excess supply of local labour? Yes. Is production and manufacturing capacity available locally? Yes. Who is going to ‘consume’ their production? Not us, were broke, or soon will be. Your response had best be realistic and affordable, not wishy-washy political spin like, ‘We must build a Knowledge Economy and increase our competitiveness’. East Asia has all the Knowledge it needs, locally, and at half the rate we would charge. So what growth?

Brian P

the question for me isn’t so much about bank regulation, its about governments acting prudently.

if we were all ‘drunk on credit’ then where were we getting the alcohol? Too much credit causes asset bubbles, and the prime player in that is the state via central banks, keeping rates too low for too long etc.

the two schools are rules based and principles based, both failed in the current crisis (USA and UK respectively)

the focus needs to shift to large entities and away somewhat from the consumer (the regulator set up a consumer ombudsman, and a great personal finance site while
Rome burned in the background), brokers (nice and small, easy to push around) were regularly fined thousands of euro for minor breaches while large banks could make errors in the millions and until late 2008 not a single one faced any fine!

we don’t need more rules, we just need the right rules and the focus to be in the right place.

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