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To Boost Job Creation, Fix the Skewed Financial Sector

Christopher Colford's picture


Will any government be brave enough to let a big bank fail? (Credit: Ian Kennedy, Flickr Creative Commons)

Five frightening years after the meltdown of the global financial system – with the world’s advanced economies stuck in a painful slump – policymakers are still struggling to reinvigorate job growth. If the unemployed were awaiting some tangible initiative from this summer’s G8 summit, they were surely disappointed: Last week’s G8 summit communiqué offered only boilerplate assertions that “decisive action is needed to nurture a sustainable recovery and restore the resilience of the global economy.”

The financial fiasco of 2008 left human wreckage in its wake. An additional 120 million people worldwide were plunged into poverty at the nadir of the crisis, wiping out years of development progress. According to the World Bank's most recent World Development Report, there are now about 200 million unemployed worldwide; 1.5 billion only marginally employed in tenuous jobs; and 2 billion dropouts from the workforce.  

Vigorous job creation in the private sector must be fueled by capital delivered through a functional financial sector – but the risk of systemic dysfunction now chills global finance. Lawmakers’ inability to craft coherent financial reforms is a major factor undermining confidence and thus hobbling job creation. Fears of another financial calamity will, alas, be justified until stronger laws  and clearer regulations restore public faith that the financial system is able to absorb and recover from sudden shocks.

The threat of systemic instability preoccupied about 100 central-bank officials, financial regulators and bank supervisors – from 63 countries – who gathered in Washington this month for the 13th in a series of annual seminars on the policy challenges  facing the global financial system. Their anxiety was palpable: anxiety about chronic policy drift, excessive financial risk-taking, and continuing economic vulnerability.

The extreme concentration of the international financial industry remains a danger to the broader economy. Just 28 global-scale “Systemically Important Financial Institutions” (SIFIs) now hold about $43.3 trillion – about two-thirds of global GDP. A relative handful of  global-scale megabanks, investment houses, brokerage firms and insurance companies seem “too big to fail” – but they’ve also become “too big to manage.” Their trading portfolios are so complex that they baffle even their own executives, as JPMorgan Chase’s leaders abruptly discovered in 2012, when they were  blindsided by the $6 billion “London Whale”  trading loss.

The suspicion persists that the pernicious “too big to fail” doctrine will again be invoked if regulators must manage a systemic crisis. Some policymakers, seeking to calm public fears, claim that “too big to fail” is a thing of the past – but finance watchers fret  that it’s still regulators’ likely default option. If a giant institution should falter, threatening to bring down its counterparties in the interlinked global financial network, would any government be brave enough (or foolhardy enough) to let it fail, thus inviting another Lehman Brothers-like panic?

The financial industry has been happily taking advantage of the implicit “too big to fail” safety net to make ever-more-lucrative and ever-riskier gambles – and to engage in “unbridled competition over who can run their bank more irresponsibly” – according to the distinguished Financial Times columnist Martin Wolf: “Governments have provided ever stronger safety nets. Profit-seeking bankers have responded by making their institutions increasingly fragile: The desire to make banks safer allows bankers to take more risk.” Wolf accused the U.K. banking industry of “malfeasance and incompetence” – offering a devastating critique of the U.K. financial industry’s “heads we win, tails the taxpayers lose” self-interest: “One cannot read the [U.K. Parliamentary Commission on Banking Standards’] report without feeling real anger. The banking industry has taken the public for a ride. Despite substantial and welcome reforms, it still does so. The argument [the banking industry] makes is that it is too important to reform. In fact, it is too important not to be reformed.”

The continuing fragility of the international financial architecture was Topic A at the recent regulatory conference in Washington, which was jointly organized by the Board of Governors of the U.S. Federal Reserve System; the International Monetary Fund (IMF); and the World Bank, through its Vice Presidency on Financial and Private Sector Development (FPD).

The conference-goers took heart from pragmatic speeches about financial safety and soundness by Federal Reserve Chairman Ben Bernanke, IMF Managing Director Christine Lagarde and World Bank President Jim Kim. But the national-level regulators surely recognized that harmonizing the tangle of international regulation is easier said than done.

If job creation is the global goal, then effective financial oversight is the means to that end. Ensuring financial resilience is essential to achieving the development community’s long-term goals – ending extreme poverty and boosting shared prosperity – as the World Bank’s FPD Vice President Janamitra Devan reminded the conference. The financial system lubricates the gears of capitalism, he said, helping deliver the capital and inspire the investment that allows for job growth.

A thriving financial sector, he said, is essential to the success of the private sector – which must create 90 percent of the jobs needed to meet the world’s imminent demographic surge. As the Bank’s “World Development Report 2013” has documented, 600 million private-sector jobs must be generated within the next 15 years – an unprecedented pace – just to keep pace with the coming expansion of the global labor force.

“Robust financial systems can help inspire a virtuous cycle of growth, lifting millions of people out of poverty. Resilient financial systems can help prevent millions of people from falling into poverty whenever a crisis strikes,” as Devan told the conference. “The role of responsible leadership in finance is thus pivotal: By ensuring that capital flows effectively toward its most productive uses – and by ensuring that financial systems are resilient enough to withstand sudden shocks – sound finance contributes to meeting the job-creation challenge.”

Despite the dangerous policy drift on issues like “too big to fail,” the conference gave financial regulators  a valuable chance to discuss and perhaps refine their contingency plans – and to ponder how to manage another potential shock to the financial system.

Finance is inherently volatile, and banking crises tend to occur frequently: Between 1970 and 2011, 147 financial crises have struck 116 countries, according to World Bank research. Experts warn that another financial crisis is destined to happen, even if economists cannot predict exactly when it will hit or how severe it will be.

“The global economy and taxpayers everywhere are still seriously at risk,” warns Financial Times columnist John Plender: “The balance sheets of Britain’s largest banks still amount to 400 percent of the economy, which is too big for comfort. Their culture is rotten. . . . Both the UK and the world remain hostage to unreconstructed bankers and their powerful lobbyists, to whom government ministers are extraordinarily deferential.”

It’s been nearly three years since the passage of the landmark Dodd-Frank financial reform law in the United States. But policymakers in the world’s leading financial centers have failed to clarify the contours of post-Dodd-Frank financial regulation.

With the nightmare of 2008 still fresh in the public’s memory, lawmakers must finally give the world’s financial regulatory bodies the policy direction they need to manage an eventual crisis – lest the financial system again find itself ill-equipped to pursue a rescue operation, if another Lehman Moment should strike.

 

Comments

Submitted by H. John Wilson on

Leaving the UK, and the US and European banking systems - the emerging market banks and hopefully regulators often have a somewhat different view. Their banks and their banking systems faired reasonably well from 2008 onwards. Surely, there were and still are secondary effects from global economic slowdown and from in particular European banks retrenching. Their banks are well capitalized, with decent profitability and liquidity, but suffering if anything from slow lending growth. The rate of growth seems to be independent from the size of individual institutions, but rather a function of lack of demand in general and bankable demand in particular. Some banks are taking on the challenge to grow into SMEs but this is inherently risky business and even if successful will take time to generate what policy makers so dearly desire - job growth.

There were many factors involved in the Western European / US Financial crisis of 2008 onwards. One observation seldom discussed was the fact that there were good banks and bad banks, as well as good regulators and bad. And before we crucify JP Morgan and the London Whale - remember that JPM can actually handle a USD 6 billion loss and still make a profit for the year. Equally interesting is the return of financial regulationa and supervision in the UK to the Bank of England, as the UK FSA was not entirely on top of vulnerability of Northern Rock's capital markets funding of mortgages or the magnitude of RBS' leverage finance business.

Lawmakers in many developed markets are busy raising regulatory requirements and "out-basel" each other. Surely, that will make the financial systems more stable, but there is a cost. As with speed limits, the lower the speed the less traffic deaths, and it's possible to approximate zero deaths - at which point no one will arrive to their destination or nothing will be delivered. The costs of excessive or more stringent regulations are less lending to SMEs, to job creating private companies. Perhaps it's time for lawmakers to consider why certain banks failed while others did not, and why some regulators did less well than their peers. A micro look bottom up may yield some interesting observations.

Submitted by Theo Onadeko on

This big picture is well captured but I am curious to see financial regulators around the globe include # of jobs created in their oversight functions and give it same order of priority as capital adequacy and other bank stability measures.

Maybe something to take to the Basel Accord

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