BOE Governor Discusses Financial System Reform

In an October 20, 2009 speech before the Scottish Business Organizations in Edinburgh, Bank of England Governor Mervyn King weighed in on financial system regulatory reform. Among other things, he discussed moral hazard associated with governments coming to the rescue of troubled financial institutions and the need to address the “too big to fail” or, as he described it, “too important to fail,” issue. His insights are relevant far beyond the boundaries of the United Kingdom.

He asserted that there are two ways to address that problem: “One is to accept that some institutions are ‘too important to fail’ and try to ensure that the probability of those institutions failing, and hence of the need for taxpayer support, is extremely low” and “The other is to find a way that institutions can fail without imposing unacceptable costs on the rest of society.”

The first approach could be pursued by requiring banks to “take out insurance in the form of ‘contingent capital.’” Contingent capital would essentially be debt or preferred equity that automatically converts to common equity before a bank becomes insolvent. The theory behind contingent capital is that its highly dilutive impact would create disincentives for financial institutions to take the kind of excessive risks that would imperil their survival. Nonetheless, King argued that drawbacks would make prospects for that approach’s success uncertain.

The second approach would require segregating financial institutions’ basic role in intermediating savings to finance investment from their riskier activities such as proprietary trading. Under such an approach, the government would provide guarantees only for the basic banking services. Former Federal Reserve Chairman Paul Volcker supports a variant of this approach in which banks would be barred from owning or trading risky securities for their own accounts. Simon Johnson, former chief economist of the International Monetary Fund goes even farther in raising the question as to whether “we have to break up the biggest banks.”

For now, there remains no consensus on how to address the “too big to fail” issue. In the United States, the debate on financial system regulatory reform has taken a backseat to the health reform discussion and it remains to be seen whether King’s, Volcker’s, or Johnson’s insights will receive serious consideration. Historical experience suggests that the passage of time and onset of economic recovery will probably reduce the scope of financial system reform emerging in the wake of the recent crisis.

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Data Highlight Unfolding U-Shaped Recovery

Recent economic data continues to suggest that the U.S. is probably near the bottom of its recession or in the very early stages of resuming economic growth. At such junctures, there can be fluctuations between growth and contraction in some sectors of the economy. At the same time, some sectors can lag when it comes to a return to sustained growth.

In the near-term, aside from Q3 GDP, for which the growth figure will likely be distorted by the “cash for clunkers” program (final demand will be a better indicator), overall growth over the next 2-4 quarters will probably remain sluggish (real annualized rate of 2% or less for most of them and for the 2009 Q2-2010 Q2 timeframe as a whole).

A “U-shaped” scenario does not represent a “new normal” to use the lingo that has proliferated in the media. Instead, it reflects the historic experience following the collapse of asset bubbles that leave a substantial debt burden in their wake. During such times, those who accumulated the sizable debt burdens tend to deleverage. With respect to the housing bubble, it was U.S. households that accumulated a historically high debt burden. Now, households are continuing to deleverage. Today’s higher than expected contraction of consumer credit is just the latest confirmation of the deleveraging trend. Such deleveraging will tend to restrain growth in real personal consumption expenditures, which still comprises roughly 70% of GDP.

Looking ahead, the labor market will likely remain a significant drag through next year, even as the unemployment rate probably peaks early next year and then begins to slowly decline. In addition, there is a structural component to the unemployment rate. Not all jobs will return. Certain sectors will likely remain notably smaller than they were in the past following the recession.

The labor participation rate, which has fallen to 65.2% of the civilian noninstitutional population could reach or drop below 65%. To put this into perspective, during the 1990-99 timeframe, the labor participation rate averaged 66.7% of the civilian noninstitutional population. At the present rate (65.2%), the labor force is 3.55 million persons smaller than it would have been at the 1990-99 labor participation rate.

An inefficient employment services sector will likely undermatch and frequently fail to match qualified employees with employers who have openings. Such a phenomenon could further slow the recovery in the job market, lengthen the duration of unemployment, and possibly contribute to some unemployed workers leaving the labor force altogether.

All those developments will likely translate into elevated consumer and real estate loan delinquencies and charge-offs and reduced growth in real personal consumption expenditures. In turn, dozens of additional bank failures are likely in coming months. A brief burst of growth in corporate profits brought about due to higher productivity/lower wage expenses could slow markedly afterward until top-line revenue growth picks up. Inflation will remain abnormally low through the rest of this year into at least part of next year. In response, the Fed will maintain its present monetary policy stance through the rest of this year and probably into at least part of next year.

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