Will bankers ever learn?

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PARIS — For a week it looked as though banking was not “as safe as houses” (a phrase that has seemed singularly inappropriate recently), but instead would turn into a “house of cards” that might be blown down with a puff of wind.

The main concern in Britain has been the potential effects of the banking crisis on the economy generally at a time when energy and food prices are rising and inflationary pressures are growing.

The media have tried to explain what went wrong and the way in which the banking system works or, perhaps we should say, in which it has not worked. Commentators have had difficulty describing the different instruments used by bankers to package loans into tradable securities that disguise the risks involved.

In the view of many, the bankers either did not understand the risks or willfully hid them and should be made to pay for their mistakes, although how this can be achieved is not made clear. There has been a particular outcry at the payment of mega-bonuses to managers who have lost so much money for their shareholders and brought their institutions to bankruptcy or near bankruptcy.

This has been accompanied by schadenfreude, as top-earners will lose their jobs and may have to sell expensive luxuries. There is, however, sympathy for the backroom and junior staff who will receive little compensation and will not find it easy to get new jobs.

The “short sellers,” whose activities in financial stocks have at least temporarily been stopped, have been rightly or wrongly made one of the main scapegoats, but the regulators have been widely blamed for allowing the mess to occur. Shareholders in institutions that have been bankrupted or had to be taken over at rock-bottom prices are asking why measures, such as the ban on short selling, were not taken earlier.

Prime Minister Gordon Brown has been quick to blame the crisis on international factors beyond his government’s control. It may well be that the discontent over his leadership within the Labour Party will be checked at least temporarily. A leadership election at a time of crisis would be seen as self-indulgent and damaging to the party.

Britain’s borrowing requirements will inevitably rise substantially. This will fuel inflation and could force tax rises at a time when real incomes are declining. The opposition Conservative Party has blamed the government for encouraging the huge growth in credit over the last 10 years that have fueled the crisis.

Why did U.S. and British authorities fail to note the similarities between the rises in housing and property prices in their countries and the asset price bubble in Japan in the 1990s, which led to Japan’s “lost decade”? There are some important differences but the basic lesson that asset prices do matter was not learned.

In the United States, Britain and Spain, the nub of the problem has been the provision of mortgage financing for domestic properties, while in Japan the basic problem was over-lending to companies against property collateral. In both cases there was a delusion that property was a safe bet and that as the population prospered, the price of property would continue to rise.

In fact, demand is elastic and property prices, which had grown too far and too fast, were bound to fall. The mortgage lenders fueled the growth in prices by granting 100 percent (or in some cases even higher) mortgages to applicants, who could barely cover the costs of their mortgages in good times. When growth stuttered, they were unable to pay the interest due on their mortgages and repossessions soared. The loan providers in the U.S., in particular, had packaged their loans and sold them in ways that disguised the true risks involved.

Sophisticated bankers should have assessed these risks, but they did not want to fall behind their competitors in the race for growth. So even if they did understand the risks (and this seems doubtful), they joined the bandwagon.

Banks leverage the funds deposited with them to lend to others. They can only do this if customers are confident that sufficient funds are held by the bank to meet demands from depositors who want to withdraw cash. Once confidence, so essential for effective banking, disintegrates, there is nothing to prevent a bank from bankruptcy except a guarantee on deposits from the government. This had to be given and other measures including nationalization taken to stave off a disastrous run on the banks.

The crisis has not ended, even if there is now a respite; we do not yet know what the fallout will be for the rest of the economy. The market economy has taken a severe knock, but the alternative of a socialist or planned economy, which demonstrably failed, is unlikely to be tried in Western economies.

Unfortunately, the remedies adopted by the U.S., where investors have suffered severe losses while mortgage lenders have been saved by the taxpayer, will inevitably discourage investment in financial institutions that remain, however much we may dislike or distrust them.

The economies in the U.S. and Britain need a period of calm while banks recheck their risks and an orderly market in interbank loans is re-established. Regulations will no doubt be tightened and oversight of the banks strengthened.

Property prices in Britain had risen too high and too fast. They must fall sufficiently to make it possible for people on average salaries to get mortgages that they can afford. But too much regulation will hamper competition and decrease efficiency. Regulations need to be applied flexibly and pragmatically so that Britain’s international role in financial services is preserved.

Hugh Cortazzi, a former British career diplomat, served as ambassador to Japan from 1980 to 1984.