A blueprint for avoiding financial crises

Mervyn King, former governor of the Bank of England, has written the most important book to appear in the wake of the financial crisis—The End of Alchemy: Money, Banking and the Future of the Global Economy.

Unlike others, King has resisted penning a blow-by-blow account of the financial crisis to justify his actions. Instead he gives a thoughtful critique of our present banking and financial arrangements. These, in his view, are so seriously flawed that without substantial change we will be plagued by recurring, and increasingly severe, financial crises. Though Canada escaped lightly in the recent crisis, we may not be so fortunate in the future. King does not shy away from offering a radical blueprint for the future.

King claims the business of banking depends on sheer alchemy, and a fragile alchemy at that. Banks offer long-term credit to borrowers and finance themselves with short-term funds. This process works well in normal times. Yet it falls apart when more than a small fraction of the funders try to withdraw their funds because banks’ liquid assets cannot meet substantial demands for withdrawal. Any hint that a bank cannot meet customer demand starts a slide towards failure as more customers try to withdraw, and doubts about one bank can quickly spread to others.

Bank efforts to reduce risk through diversification also depend on alchemy. They bundle risky investments together so that individual risks normally tend to cancel out. Doubts, however, are raised about all investments in a crisis and risks all move together. Banks then face threats to their solvency that would be unimaginable if their risks still offset each other.

The fragility of banking creates a dilemma for central bankers and regulators. King treads down a well-worn path advocating “narrow banking” following the footsteps of many others, including a flurry of Nobel Prize winners. Narrow banks would hold only liquid, safe assets enabling them to always meet withdrawal demands. They are too safe to fail.

Narrow banking faces some practical difficulties. The business of funding long-term credit with short-term funds may migrate outside the narrow banks, posing the same instability narrow banking was intended to overcome. King rules out this possibility by restricting short-term funding to narrow banks and only narrow banks. The current lending of banks would need to be replaced by institutions that borrow long-term to finance lending. They could be financed by term-deposits, bonds and other forms of debt.

More important, narrow banking cannot be put in place overnight. King suggests a transition of 10 to 20 years over which the unstable alchemy will still cast its shadow. During that time banks will be vulnerable to collapse as they are now, though to lesser degrees as time goes on.

To prevent recurring crises over the transition, central bankers, in King’s view, must change their ways. They must no longer follow the longstanding prescription of Walter Bagehot to lend freely against good collateral to solvent banks. The line between solvency and insolvency blurs in the heat of a crisis and modern banks hold fewer assets that can serve as good collateral. Central bank lending runs the risk of propping up insolvent banks.

Further, lending freely to deal with one crisis sows the seeds of future crises. Banks will be willing to take on greater risks when they know they will have ready access to liquidity in times of need.

King proposes to replace the traditional lender of last resort function of central banks with a “pawn broker for all seasons” to insulate central bank decisions about emergency lending from the heat of a crisis. The pawn broker’s lending would be based on pre-established lines of credit determined by pledged collateral with different assets counting toward collateral according to their risks. This arrangement forces banks to weigh their risks against the line of credit that they need and pledge assets accordingly. The pre-established lines of credit would give central banks clear limits with respect to their obligations to lend.

Overall King’s message is depressing. Yes, he provides a blueprint for avoiding the devastation wrought by financial crises. But the plan requires a drastic shrinkage of bank activities so they are no more than a shadow of their current selves. It also requires strict limits on central bank lending. Reality in the form of political pressures may undermine his plan. Will governments have the courage to take the needed actions or will financial crises be a normal feature of economic life?

We should be grateful to Mervyn King for providing such food for thought. It was a far greater service than a personal memoir could be. Let’s hope that officials and politicians throughout the world read and digest it.