We Should Invent A Cure For All Known Diseases

Job done. Not.

I've just read the much trailed G20 open letter Brown has signed jointly with Angela and Sarko. It says the G20 should "design an international regulatory framework for the financial sector that puts it at the service of the real economy".

Er, yessss... only, if we knew how to do that, we wouldn't need the talcum powder.

Well, OK, they do go on to say banks should have better remuneration "governance", more remuneration transparency, more emphasis on the long-term, and bonuses that can go down as well as up.

But how exactly? Do they seriously imagine banks don't already have remuneration governance systems? Do they think current bonus structures ignore the long-term, or can't deliver cuts as well as increases?

And who's going to decide whether bonuses are "excessive"? And how would governments possibly enforce any limits?

The truth is that this letter is a purely political document, aimed solely at domestic electorates. As it says:

"Our citizens are deeply shocked at the revival of reprehensible practices, despite taxpayers' money having been mobilized to support the financial sector at the height of the crisis."

Translation: we, your leaders, are on the side of the citizens and the angels against the evil bankers; we go to the G20 meeting to fight for you; it won't be our fault when the arrogant self-serving yanks veto the whole deal.

But as we've blogged before, tackling bankers' bonuses is tackling the symptom not the disease.

The fundamental issue we face is the so-called "Iceland problem" - we taxpayers are collectively guaranteeing a banking system that has grown far beyond our capacity to back that guarantee. Worse, we are providing the guarantee at virtually no cost to the banks. As the Prof puts it in his first post-vacation blog:

"The financial sector is too big throughout the overdeveloped world in part because much of it enjoys a free state guarantee against default on its unsecured debt. Retail deposits are explicitly insured, but at premiums that imply a taxpayer subsidy. Other counterparties of banks and other systemically important financial institutions also benefit from implicit default guarantees. The cost of capital to the banking sector is subsidised, causing the sector to be too large."

So what can we do?

As we've blogged before, we'd start by separating high street retail banking from wholesale "casino" banking. The taxpayer guarantee would be explicitly confined to retail depositors, and in the event of a bank insolvency, any wholesale depositors or bond holders would be on their own.

Once wholesale creditors understood that, minds would get concentrated. High risk banks would suddenly find their access to cheap funds severely curtailed. The whole issue of risk would be much more centre stage.

In that world, banks and their investors would have a much greater incentive to rein in their traders and loans officers. Bonuses would be recast by the banks themselves, rather than by a bunch of blundering incomes policy bureaucrats.

Of course, for such a regime to be effective, the authorities would have to show they really were prepared to let an insolvent bank go (by which we mean allowing it to be taken over by a so-called "special resolution regime", run by the authorities themselves and designed to liquidate the failed bank in an orderly way).

Which brings us to the case of Lehmans.

Because as we recall, it was the US Treasury's decision to let Lehman go in September 2008 that triggered the near-collapse of the entire global financial system. Even though it had no retail depositors and might in some sense have been easier to let go, the ensuing panic in the wholesale markets showed that everybody had been assuming the US taxpayer guarantee applied to all Lehman's liabilities, including wholesale. And if a player as big as Lehman could go, nobody was safe.

So does that mean we can never let a big bank go? That in reality we're locked in, whatever the niceties of our banking regulations may say?

Certainly there are plenty of people who reckon US Treasury Secretary Paulson made a huge error over Lehman: if he didn't understand the bank was too big to fail he was an idiot (just like his boss). Indeed, regulators in this country even try to excuse their own lamentable failures here at home by fingering Paulson. In all seriousnness the FSA's Hector Sants says:

"...it was a mistake to let Lehman fail... Without the future market shock created by Lehman Brothers' collapse, RBS may not have failed."

But we've just had an interesting insight into the circumstances of that Lehman weekend (HTP Jeremy P). According to Paulson himself, the real culprit, the man who really broke the bank, was none other than our own A Darling Esq.

As you recall, over that weekend Barclays was negotiating to take over at least the good bits of Lehman (see here for useful account). But they and the UK authorities would only go ahead if the US Treasury offered to guarantee a big chunk of Lehman's liabilities.

Unfortunately, they omitted to make that crucial point clear to Paulson until the very last moment:

"Paulson has blamed Lehman's demise on Alistair Darling's failure to let Washington know of his misgivings until it was too late. Paulson has told journalists that during a transatlantic phone call the chancellor said he was not prepared to import the American "cancer" into Britain – something Darling strongly denies."

Now of course, Paulson has an axe here, but his account has a ring of authenticity. Brown/Darling's misgivings would never have been an easy message to convey to Paulson, and there is every likelihood they avoided voicing them until the last possible minute - that would be typical of the spineless way this government conducts itself (cf Brown's entirely inconsistent messages to the Libyans and the yanks over the Lockerbie bomber's release).

On the more general question, we agree with Bank of England Governor King: if a bank is too big to fail, it is too big. Which is another reason why our regulators should focus on breaking up the big megabanks into their retail and wholesale components. We simply can't afford banks that are too big to fail.

Unfortunately, as the spat between Paulson and Darling highlights, the chances of the G20 agreeing anything meaningful on that or any other aspect of bank regulation are approximately zero.

Which is a worry.

PS As widely reported, yesterday's updated GDP forecast from the OECD shows the outlook starting to improve in most major economies with the 2009 decline in G7 GDP revised from -4.1% to -3.7%. The glaring exception is the UK, where the OECD have shaded their 2009 numbers down further, from -4.3% to -4.7%. So much for Gordo's green shoots. And the OECD warns: "Countries need to prepare for the removal of the exceptional degree of support afforded by current monetary and fiscal policy stances. In this regard, [they need to prepare] credible exit strategies and fiscal consolidation plans now." We couldn't agree more (eg see this blog).