Everyone seems to have a view as to how to tackle regulatory reform in the wake of the financial crisis and most of the suggestions involve cutting pay and bonuses in one form or another. Rampant capitalism is blamed for an age of excess, with bankers reaping their exorbitant rewards.
But while this provides a great media story with talk of investment banker bonuses well into seven or eight figures, it does not provide a sensible guide as to what we should do in response to the financial situation. Pay and bonuses are a side issue in the economic debate. We may well be angry at what investment bankers pay themselves, but emotion doesn’t make for good policy.
We need to take a long deep breath before we embark on any regulatory response. The experience of Sarbanes-Oxley in the US shows that the easy political option can very quickly damage the economy.
I believe the problem with investment banking is not too much capitalism but too little. Being too big to fail, with the taxpayer always ready to step up to the plate in a crisis, distorts decision making and provides a considerable incentive to embark on very risky activities. For the world’s largest economy the consequences are all too clear with the American government’s financial guarantees now totalling $24trn.
What we need is a set of regulatory reforms which, in the words of the Bank of England’s Deputy Governor Paul Tucker, “put capitalism back into the heart of capitalism”.
The financial crisis has actually increased the market power of the biggest institutions and this is where future change is likely to be most apparent. Separating investment from retail banking and the development of limited purpose banking (similar to mutual funds) are all on the table, although they are not without difficulty.
The aim will be to create a much more competitive financial system with many more providers. Regulatory changes such as improving liquidity requirements, creating living wills for banks and quasi separation through capital rules may all have a role to play. But the single most important policy will be introducing more competition.
Putting capitalism back into capitalism could transform the future financial landscape.