What went wrong

I once asked an American friend to come and talk to the Centre for the Study of Financial Innovation. He told them that he was against it. That put him ahead of his time, but Mervyn King agrees with him.

In his decade as Governor of the Bank of England, he had seen what innovation could do, in good times and bad — in crisis, and in the fitful recovery that followed. He has resisted any temptation to write a memoir with himself as hero. Instead, he has set out to explain what went wrong and what must change to stop it happening again—and since we all need to know that, he wanted to write, not in economists’ algebraic shorthand, but in English.

That shorthand gave an illusion of certainty. It encouraged banks to believe that they could measure the future and put a price on risk — and if they could measure it and price it, they could trade it. Innovation showed the way, and its margins of safety could be narrow. When they disappeared, another illusion was put to the test — the belief that a bank might be short of ready cash but still solvent. In practice, any bank that cannot open its doors and meet its obligations is out of business. So, on one fraught afternoon, the Bank of England’s chief cashier had to write Lloyds and the Royal Bank of Scotland a cheque for £60 billion.

The big banks, to King’s mind, were on a two-way bet. If they made money, they kept it, and if they lost, they were too big to fail, so the taxpayer would foot the bill. (No wonder that he and they did not get on.) With the odds stacked like that, he suspects, it will happen again.