Tony Curzon Price
October 9th 2008
Face up to it: the Brown re-capitalisation plan may not work. The banks have relied to a massive extent on Credit Default Swaps, a sort of insurance on lending. They have given themselves false comfort, and in some cases very real cash-flow, on an insurance pyramid that will not hold-up under even modestly higher default rates. Liabilities under these insurance contracts are vast. One hedge fund was insuring 100 times its cash base before it went under. If the banks that we are now the proud part-owners of end up being heavily exposed to these liabilities--the total CDS market is measured around $50 Trillion, almost 1000 times more than the Brown rescue--we should just cut our losses and let the banks go under.
The problem is the protection of the real economy. The Federal Reserve has shown the way here, with its direct lending to companies, started 2 days ago. We should start a new state bank, recruit bankers and accountants from the City, and get them to work on lending to the real economy. At first, they will not have the time to distinguish good and bad loans. They will have to be lax but short-termist in their lending decisions. Their task will be to rapidly and efficiently become ``relationship bankers''--understanding the underlying businesses they are lending to and setting appropriate and gradually tougher lending terms. Once financial flows to the real economy are safe, the state bank should be broken into 10 identical pieces and with 9 sold to private investors who will operate in a new regulatory regime. The tenth should remain in state hands, as a benchmark bank, a way for the state to stay close to what is happening in the markets.
It is disturbing that the Brown re-cap was hatched by the Treasury, the Bank of England and top bankers. The trouble any regulator has is that the people who best understand the business and the crisis are the people you are trying to regulate. This is the basis of every regulatory capture. You cannot trust what the knowledgeable say to you. If the liabilities of the banks start to mount, let's make sure this plan B is ready to be deployed.