The war with the banks has to be fought on two fronts

Trying to prevent another financial crisis was always going to require fighting on two fronts. The first, which gets most of the attention, is to change the rules and framework of regulation. That involves imposing higher capital ratios and leverage ratios, as well as restricting the activities that banks can engage in. Some progress has been made on that front. The second involves political change, and here I’m not sure any progress has been made. 

The banking sectors in most countries were responsible for the financial crisis. Increases in leverage on the scale shown here were just courting disaster. Big mistakes were made by regulators in allowing this, but the source of the problem was the actions of those in the financial sector. That crisis showed us that ‘too important to fail’ creates a huge market distortion, which mainly benefits those working in banks. The battle to change the status quo is therefore of huge importance.

I’m not an expert in these matters, but my impression is that some progress is being made on the first front. Banks have of course resisted much of this, saying that it would discourage lending and therefore hurt the recovery. Stephen Cecchetti argues that this has not happened. What has been hit is bank profitability, which indicates changes are having the desired effect. Cecchetti suggests as a result that more could be done, and this seems an understatement. Recent work by the IMF suggests that big banks continue to attract large implicit subsidies, while Admati and Hellwig present a well thought out case for much higher capital ratios. Until this happens, our money will continue to help fund bank bonuses.

So on the first front, some progress has been made but much more needs to be done.[1] However the recent case of Citigroup and the US congress illustrates all too clearly why we need a second, more political battle. [2] The story is very simple. The Dodds-Frank act that became part of US law in 2010 prevents US banks from using deposits to undertake certain ‘speculative’ activities. That was one of the victories on the first front discussed above. One of these speculative activities, and possibly the most dangerous in scale, is derivatives trading. On the 11th of December last year, as part of the last minute deal to prevent another US government shutdown, congress passed a provision that exempted derivatives from Dodds-Frank. The provision was based on drafting by the US bank Citigroup.

Why would Congress undo its own legislation in this way? The answer is not hard to find. US banks contribute huge amounts of money to fund the campaigns of those that run for congress, be they Democrat or Republican. It spends huge amounts on lobbying. Members of government often have or will work for these banks. Of course regulators can also be captured by those they are supposed to regulate. This could all be described as institutionalised corruption.

The only big difference between the US and the UK or Europe is that these things are a little more open in the US. City contributions make up a large proportion of Conservative party donations in the UK, and the other parties are hardly indifferent to wealthy donors who made their money in the financial industry. Lobbying is extensive and there are plenty of legislators with links to the financial sector. As Tamasin Cave notes, the UK comes second only to Switzerland for the number of people moving through the “revolving door” between the finance sector and officialdom. Whether Europe’s attempts to put a cap on bankers’ bonuses made economic sense or not, the fact that the UK Chancellor and Treasury were prepared to try so hard to prevent it happening shows who calls the shots in the UK government. Similar points can be made about the extent of lobbying and industry links in Europe.      

The Citigroup case shows how any immediate gains achieved on the first front can be steadily eroded by the political influence of the banks as the memories of the financial crisis fade. Now it might have been prudent from the US banks’ point of view to wait a bit before doing this so openly. Simon Johnson rather optimistically suggests that Citigroup’s blatant move may end up with its breakup. Alternatively Citigroup may just know they have the political upper hand. In the UK, it is difficult to know where an effective challenge to banks' political power will come from, and good reasons to think that any challenge would not be successful. [3] Such a challenge would be hugely popular, but more than popularity is required to counter the influence of money and power.

[1] In particular, the importance of simple regulation that cannot be gamed seems not to have been sufficiently appreciated.

[2] The case is unfortunately not an isolated example.

[3] An example of what UK governments can try and get away with in the interests of large corporations is provided by the case of Jeremy Hunt and News Corp. In November 2010 Culture Secretary Hunt sent a memo to the Prime Minister which began “James Murdoch is pretty furious at Vince’s referral to Ofcom.” That was Vince Cable’s referral of News Corp’s proposed takeover of BSkyB. The memo argued News Corp’s case. As Stuart Weir documents, Hunt was hardly a disinterested party in this. When Vince Cable was subsequently forced to relinquish his role in the affair because of comments he made to constituents, it fell to Cameron to appoint someone who was seen as more impartial. He appointed Hunt to take over. When civil servant Gus O’Donnell was asked to oversee the propriety of the appointment, Hunt’s memo was not disclosed to him.