After six years of crisis, much progress has been made in fixing the financial system. There was, for example, a landmark European Union deal last week to make creditors rather than taxpayers foot the bill for bust banks. But there’s a huge job still to do.
In the years running up to the crisis, the financial system ran amok on both sides of the Atlantic. Among the long litany of problems was a clutch of distorted incentives, which encouraged banks to take excessive risks by rewarding success but not punishing failure. These heads-I-win-tails-you-lose incentives skewed the behaviour of individuals, banks and the entire system.
A crackdown on bankers’ pay is starting to deal with individual risk-taking. Compensation can be clawed back from financiers whose bets ultimately turn sour. There are also plans, mainly in Europe, to pay a chunk of bankers’ compensation in “bail-in bonds” – which will get wiped out or turned into lowly valued shares if a bank fails. That should get bankers to pay more attention to risk.
Creditors are also being given an incentive to make sure their banks don’t run excess risks. That’s one reason last week’s EU deal requiring creditor bail-ins, not taxpayer bailouts, is so important. Creditors will pay attention too. The work isn’t complete, though, because it is highly undesirable to bail in depositors, as was done in Cyprus earlier this year. Far better to require all banks to hold a minimum amount of capital that has been specifically earmarked for bail in. That way, creditors will know what to expect upfront.
At a system-wide level, the main one-way bet was caused by Alan Greenspan’s habit (while he ran the U.S. Federal Reserve) of riding to the rescue of markets when they tumbled but doing nothing to prick emerging bubbles. There is now general agreement that central banks need to lean against the credit cycle – not just by raising interest rates but also by requiring banks to hold more capital when credit is flowing too freely (something which is not, admittedly, a problem at present).