The Nikkei Financial Daily (Market Eye Column)., 16th October 2007

England has just witnessed a run on a bank. Depositors, frightened of losing their money, queued outside the branches of the Northern Rock to withdraw their savings. The shock was tremendous. The UK government rushed to guarantee all bank deposits against loss and the Bank of England’s prestige has taken a tremendous blow.

Nobody wants to take the blame, but the management of Northern Rock is generally agreed to have been at fault. But they did not suddenly change their behaviour. They were dependent on the wholesale market for funds and made no secret of it. When this market dried up they were left stranded.

If Northern Rock were a hedge fund rather than a bank, it would be noted that the management had made a bet which went wrong. That would be the end of the story as this is what happens in a competitive economy and indeed is a necessary part of the way capitalism works.

But banks are different. In practice, even if not in theory, as the UK experience has just underlined, their deposits are guaranteed by governments. This means that banks can borrow as much as they want at the same rate as governments, however badly they are managed.

In return for this guarantee, governments regulate banks. The aim is to stop them going bankrupt, so that the guarantee will not cost tax payers dearly. This aim has not been met with persistent regularity. Banks have gone bankrupt over the past 20 years in large numbers, not only in less developed countries, but in the US, Japan and Europe.

A key reason why successful regulation is so difficult is that managements like risk. Managements do not have the same interest as the owners, i.e. the shareholders, of companies. This is known to economists as the agent/principal problem. One aspect of this is that management is inclined towards taking greater risks than shareholders should want them to do. Financial markets are not perfectly efficient and extreme events happen much more frequently than they would otherwise be expected to do. Ninety percent of the time, returns are better and conditions smoother than they are on average, but ten percent of the time returns are negative and conditions turbulent.

From the shareholders’ viewpoint, caution makes sense in the good times, so that disaster can be avoided in the bad. But this is not in the interests of management. If they are cautious in the good times, they will not look clever and will not reap fat bonuses and may lose their jobs. In the bad times they will lose their jobs but not their capital. A lost job can be replaced, lost capital can’t. So, the balance of risk and reward means that management is inherently driven to take more risks than shareholders should want them to do. This age old problem has been made worse in recent years by the massive increase in the proportion of managements’ remuneration which is tied to the results of the business.

This is a general problem for business. It can set off big swings in stock markets, other financial assets and property and, when these come down to earth, it makes the management of the real economy very difficult. But it is a particularly acute problem for banks because, when they go bankrupt, the tax payer picks up the tab and the repercussions on the real economy are particularly acute.

The regulation of banks thus needs to ensure that the natural instinct of management to take risk is thwarted. It is clear from recent history that regulations have so far failed to do so and current data suggest that further failures are likely. The current return on banks’ equity capital in Europe and America is about three times the long-term average return on corporate equity and, as banking is a competitive industry, it must have a very similar average return. Thus, unless bank capital is increased, profits are going to fall sharply at some time in the future and this will no doubt bring further troubles. Current banking regulations are too lax, as banks are allowed to run their businesses on too little capital. The sooner the regulations are changed the better.