3.3.4.4  Measures to Reduce the Impact of Financial Instability

(This is an archived extract from the book Patterns of Power: Edition 2)

Since deregulation, the financial sector’s shareholders and employees have benefited at the expense of the rest of society – which subsequently had to bail them out.[1]  One governance challenge now is to find a way of preventing further instability.  The minimum reserve requirement has already been increased,[2] but further measures are needed.  There are divergent views on how to achieve this:

·      Governments now own more of the banking system than they used to and there have been calls for yet more public ownership.  This would be expensive to accomplish and the result would be a less flexible and innovative system, which would employ fewer people and pay less tax. 

·      Another approach would be a radical re-examination of financial sector regulation, for example to re-separate the “casino” from the “utility”.[3]  It should not be necessary to lose all the benefits of free markets, which “are not the same as unregulated markets”.[4] 

·      A third suggestion has been to break up some of the larger organisations, so that none is ‘too big to fail’, and then allow those that fail to declare bankruptcy so that they can be restructured.  An advantage of allowing some organisations to fail is that others would be more prudent –knowing that they too would not be rescued.

·      Perhaps banks ought to have more shareholder equity in relation to the funds they manage; shareholders know that they are taking a risk, and therefore expect a higher rate of return than ordinary depositors who expect to get their money back when they ask for it.[5]  The shareholder capital acts as a cushion against the risk of some of the banks loans not being repaid.

Any governance solution has to be considered on a global basis, because money can be rapidly transferred between countries – and financial services organisations can choose where to have their headquarters.  This is part of a wider subject – the restructuring of the global financial system – which is reviewed later in this chapter (3.5.5).

© PatternsofPower.org, 2014



[1] An Internet search for "heads I win, tails the taxpayer loses" retrieved over 11,000 hits in April 2014, including a Google Books citation from The Princeton Encyclopedia of the World Economy, Volume 1, by Kenneth A. Reinert, Ramkishen S. Rajan, Amy Jocelyn Glass, and Lewis S. Davis, which attributed the phrase to Paul Krugman in 1996.  This citation was available then at http://books.google.co.uk/books?id=BnEDno1hTegC&pg=PA249&lpg=PA249&dq=%22heads+I+win,+tails+the+taxpayer+loses%22&source=bl&ots=wxB-N7NRnc&sig=_vazFkrjBh9L_0G8184LY8KA0nM&hl=en&sa=X&ei=A2BZU-HZOeit0QX674CwBA&ved=0CFoQ6AEwCQ#v=onepage&q=%22heads%20I%20win%2C%20tails%20the%20taxpayer%20loses%22&f=false.

[2] The Board of Governors of the Federal Reserve System publish regulations, which were available in April 2014 at http://www.federalreserve.gov/monetarypolicy/reservereq.htm.

[3] John Kay’s article in Prospect on 17 January 2009 (already quoted above), entitled Making banks boring again, suggested a form of regulation:

“A new Glass-Steagall Act would probably not work …. Instead, structural rules should firewall the utility from the casino”. 

This article was available in April 2014 at http://www.prospectmagazine.co.uk/magazine/makingbanksboringagain/.

[4] Daren Acemoglu wrote an article entitled The Crisis of 2008, which was available in April 2014 at http://www.hoover.org/publications/defining-ideas/article/5453.  The article explains how aspects of governance were insufficient to prevent the economic crisis.  The relevant passage is:  “Few among us will argue today that market monitoring is sufficient against opportunistic behavior. Many inside and outside academia may view this as a failure of economic theory. I strongly disagree with this conclusion. On the contrary, the recognition that markets live on foundations laid by institutions – that free markets are not the same as unregulated markets – enriches both theory and its practice. We must now start building a theory of market transactions that is more in tune with their institutional and regulatory foundations. We must also turn to the theory of regulation – of both firms and financial institutions – with renewed vigor and hopefully additional insights gained from current experience.”

[5] Anat Admati and Martin Hellwig, in Part II of their book The Bankers' New Clothes, suggested that the banks should be required to raise more shareholder capital as a hedge against bad loans.  On 8 April 2013, Russ Roberts interviewed Anat Admati about the book, focusing on the need for more shareholder capital; a podcast, and a transcript, were available in April 2014 at http://www.econtalk.org/archives/2013/04/admati_on_bank.html.