Banks must see the debate has changed

August 28, 2009

Regulators are rarely accused of being too candid. But Adair Turner’s observation that the financial sector is too large has seen the chairman of Britain’s Financial Services Authority swamped by a wave of protest.

Executives, lobby groups and even Boris Johnson, London’s Mayor, have responded with dire warnings about the risks of undermining the financial sector. This knee-jerk response shows the industry still fails to understand the consequences of the crisis it helped to cause. It is high time bankers engaged in a proper debate about their future.

The criticism of Turner takes two familiar forms. First, financial services businesses and their employees pay lots of tax. Second, tougher regulation could drive this valuable activity elsewhere. Both arguments have some limited merit. However, this narrow defence fails to address the broader question of the banking industry’s function, and its relationship with the state.

It is true that big banks have in the past paid a lot of tax, as have most of their employees. However, these historical receipts must be weighed against the trillions of dollars of public money that governments have been forced to commit to prop up their banking systems.

It is also the case that unilateral action taken by any one country would risk driving business offshore, much as heavy-handed regulation by the U.S. helped create the Eurobond market in the 1960s and 1970s. Moreover, not all the financial sector is equally to blame. Most of the insurance industry operates without direct government support.

But arguments about tax and competitiveness miss the point. There is no realistic prospect of Britain acting alone to rein in its banking sector. Like other regulators, Turner is acutely aware that action must be co-ordinated internationally by governments.

The bankers have also failed to address Turner’s central question, which is why the financial services industry has grown so large. Benjamin Friedman of Harvard University points out that, from the 1950s to the 1980s, the finance sector — excluding insurance and real estate — accounted 10 percent of U.S. corporate profits. In the first half of this decade it was 34 percent.

If banks exist to intermediate capital flows and allocate credit in the economy, what explains this shift? And if the industry is as fiercely competitive as its proponents often claim, why was it so profitable?

The crisis has revealed that much of the banks’ growth was the result not of genuine financial intermediation but a rapid recycling of risk with ever-increasing amounts of leverage. Subsequent catastrophic losses have shown that most of these profits only ever existed on paper.

More fundamentally, taxpayers have been revealed as the ultimate guarantors of the financial system. This is incompatible with a lightly regulated banking system, or one that has the capacity to overwhelm the resources of its home nation.

These complex issues cannot be resolved by any one country or regulator. Nonetheless, the case for reform is overpowering. Shallow arguments about tax and competition are no longer an adequate defence for a swollen financial sector. The banking industry needs to show that it recognises that the debate has been fundamentally recast.

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