THE END OF ALCHEMY
Money, Banking, and the Future of the Global Economy
Mervyn King
W W Norton
368 pages; $28.95
Running or regulating a bank is not for the faint hearted. Banks raise most of their resources as deposits and borrowings, which can be called back immediately or at short notice. A majority of these resources (about 65 per cent for banks in India) are used to give loans that cannot be readily converted into cash. The rest is invested in securities whose convertibility into cash depends on the moment in time. In 2008, at the onset of global financial crisis, even Indian markets froze. No wonder the great financial economist Merton Miller called banking a disaster-prone 19th century technology.
A lot of effort goes into sustaining what Mervyn King, governor of the Bank of England from 2003 to 2013, calls the "alchemy" of modern monetary and banking systems in his latest book. This alchemy is the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand, and that money kept in banks can be taken out anytime. In times of crisis, upholding this belief requires governments or central banks to print money. When a bank fails to get the markets to convert its securities into cash, central banks act as "lenders of last resort", extending loans against collateral to ensure banks honour their claims. This involves printing money. The alchemy ultimately rests on the governments' ability and willingness not to abuse their power to print money.
For the last five years of his tenure, Mr King presided over Bank of England's work with the Treasury to mitigate the effects of the global financial crisis and to reform the financial system. The banking reforms encompassed capital requirements, liquidity norms, separation of investment arms of banks from retail arms; a framework for handling failure of banks, including a provision to write down certain creditors' interests into capital, so that tax-funded bail-outs become less likely. Reforms also included changes in regulatory architecture that made the Bank of England much more powerful.
In Mr King's view, these reforms fall short. He says the "alchemy" must end, and it can only happen if central banks transform into "pawnbrokers for all seasons". Under this model, Mr King says, central banks would be ready to lend against any collateral at any time an amount that is suitably less than the value of the collateral (ie, after applying an appropriate "haircut"). Banks would pre-position their assets with the central bank, which would assess their quality and decide on the appropriate haircut. These assets would not be used as collateral for other borrowing by the bank. The regulation would mandate that the amount the central bank agrees to lend against the pre-positioned assets and the reserves the bank holds with the central bank must be more than or equal to the bank's total demand deposits and short-term unsecured debt (up to one year in maturity).
Mr King's proposal would mitigate effects of unexpected withdrawals or freeze in markets. It would also force banks to hold more capital and reserves. This would create a perception of safety and reduce the chances of bank runs, which in turn would make systemic crisis less likely. This would do for institutional lenders to banks what deposit insurance did for retail depositors. All good, but not easy or free.
First, the model may accentuate a crisis, if in the run-up to a crisis, haircuts are increased. Second, while bank failures will become less likely, when they do occur, the central bank will be holding assets they are not well placed to handle. Third, the proposed system of haircuts may face the kinds of problems from which the system of risk weights in banking regulations suffers. Fourth, central banks would need to build extensive monitoring capabilities to ensure the haircuts are suitable. Finally, there is an unsettled debate about whether capital is expensive for the banks.
The book would also help readers understand the intellectual and historical foundations of our financial system. For example, Mr King traces the crisis to three experiments - independent central banks targeting low and stable inflation; shift to fixed exchange rates both within Europe and in many emerging economies, particularly China; and the goal of financial stability, with removal of regulations to promote competition and allow diversification into new products and regions. These experiments have had mixed results: from unprecedented stability of output and inflation for two decades to the rise in debt levels and development of an extremely fragile banking system.
Like most people who were in charge at that time, Mr King took some flak for not doing enough before, during and after the crisis. The book hardly offers any explicit defence of his actions. Instead, it focuses on larger issues and, unlike most "crisis books", on ideas over individuals.
This book is particularly pertinent for India. We have a 19th century banking system (words of an ex-deputy governor of the Reserve Bank of India). As we build a modern banking system, we have to do deep thinking about how to make banking safe, sound, and efficient. Mervyn King's book can help in that re-imagining. From the Raghuram Rajan Committee to the Financial Sector Legislative Reforms Commission, during the last ten years, much thinking has happened on reforming India's financial system. However, most of the ideas remain unimplemented. We urgently need to think, debate, and act on the kinds of questions this book raises.
The reviewer is Senior Consultant, National Institute of Public Finance and Policy
