Bank Reform

Last night, Andrew Haldane (Executive Director at Bank of England with responsibility for financial stability) gave the Wincott Annual lecture (available here).  In it he argued that the evolution of British banking system away from a regime where bank shareholders have a responsibility to meet shortfalls between their assets and liabilities towards one where they have limited liability has resulted in a banking system where bank managers have become risk-taking junkies.  I was pleased to see him argue thus, particularly as he cites my solo- and co-authored work in this area - click here for a recent example.

Haldane suggests that the risk-taking incentives of banks need to be curbed by public policy.  He makes four specific proposals.

1. Banks need to hold higher levels of equity capital and the tax advantage of using debt finance should be removed.
2. Banks should hold contingent convertible securities (CoCos) which have market-based triggers.
3. A change in voting rights of banks, whereby depositors and holders of CoCos have voting rights.  This would result in banks which are hybrids of mutuals and joint-stock companies.
4. ROA should be used as performance metric for managers instead of ROE.

Martin Wolf at the FT has welcomed these radical proposals, but suggests that they maybe don't go far enough.  I for one agree with him.  My research suggests we need to rethink the whole concept of limited liability in banking (click here for slides of my speech to a group of German bankers in Munich).  It should be managers and shareholders who pick up the tab when a bank collapses, not taxpayers!  A regime with extended shareholder liability reduces incentives for bank risk taking and reduces bank risk taking to socially optimal levels.     

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