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Sunday 7 September 2008

Say farewell to gentlemanly capitalism

Tony Curzon Price foresees a new era in which finance will be as tightly regulated as pharmaceuticals

We now know the history of that cycle. A first generation of financiers, shame-faced and in political disgrace, made modest fortunes out of the public eye and by respecting the new constraints of their trade. The next generation, trained by their timid predecessors, strained at the leash of regulation; they grew bold, dabbled in unregulated Eurodollar markets and forced the end of the Bretton Woods monetary system and dollar-gold convertibility. This is the generation that offered support and expertise to Reagan and Thatcher when banking deregulation made it on to the political agenda. In Britain, it is the generation that enjoyed the first fruits of the brave new world after Big Bang in 1986.

The third generation, at the peak of their careers today, grew up to understand the true spirit of deregulation — even so far as to push it beyond the spirit, if not the letter, of the law in constructing Byzantine off-balance sheet structures, like Northern Rock’s Granite, that allowed regulated banks effectively limitless capacity to lend money. Limitless capacity created limitless desire, leading to all the perverse incentives to mis-sell we have now discovered.

So should we just roll back the deregulation of the 1980s? Should mortgages, consumer banking, pensions and credit cards all become hyper-regulated, with products, fees and terms approved by the state — while the rich, the risk-loving and the corporate live by their wits in hedge-fund heaven? In this scenario, consumer-facing regulated banking grows to look like selling drugs to the NHS: risk-averse, innovation-shy, bureaucratic. But the unregulated alternative is more like drug-dealing in a dark alley: dangerous, and sometimes delivering real highs.

Such a settlement seems to offer social pooling of risks in sensitive sectors, while giving a place for the huge global flows of modern finance. It promises to preserve both the consumer and the City.

But the trouble with this solution for today is moral hazard, which occurs whenever a contract sets up a temptation to misbehave — pretending your camera was stolen while on holiday in order to claim it on your insurance was a popular form when I was a student. Moral hazard occurs once morality has gone out of the window. In 1929, perhaps the state could still rely on gentlemanly capitalists, but today we will have to address the root cause of moral hazard: the ultimate insurance policy of the taxpayers’ guarantee that whatever banking does, it will be bailed out. This crisis has shown us that the supposedly grown-up bit of the banking industry actually operates with the social safety net of system stability. It is too big to fail, and it is no longer — if it ever really was — gentlemanly enough to stay within its bounds.

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