volcker and iceland

Former Fed chairman Paul Volcker recently gave a speech in Toronto where he talked about what kind of banking system the U.S. should be aiming for post-crisis. I think a lot of what he said is directly relevant to Iceland as well, so I'll excerpt that part of the speech here and then follow with some comments.

I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken. I’m not going to linger over what to do about it. It is very difficult. It is going to take a lot of money and a lot of losses in the banking system. It is not unique to the United States. It is probably worse in the UK and it is just about as bad in Europe and it has infected other economies as well. Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go.

So I’ll jump over the short-term process, which is how we get out of the mess, and consider what we should be aiming for when we get out of the mess. That, in turn, might help instruct the kind of action we should be taking in the interim to get out of it.

[...]

So what are we aiming for? I mention this because I recently chaired a report on this. It was part of the so-called Group of 30, which has got some attention. It’s a long and rather turgid report but let me simplify what the conclusion is, which I will state more boldly than the report itself does.

In the future, we are going to need a financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort. Financial systems always fluctuate and go up and down and have crises, but let’s not have a big crisis that undermines the whole economy. And if that’s the kind of financial system we want and should have, it’s going to be different from the financial system that has developed in the last 20 years.

What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system.

This kind of system was in place in the United States thirty years ago and is still in place in Canada, and may have provided support for the Canadian system during this particularly difficult time. I’m not arguing that you need an oligopoly to the extent you have one in Canada, but you do know by experience that these big commercial banking institutions will be protected by the government, de facto. No government has been willing to permit these institutions, or the creditors and depositors to these institutions, to be damaged. They recognize that the damage to the economy would be too great.

What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.

But I think it does say that those institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution. They may make a lot of money and they may have a lot of fun, in the short run. It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflict of interest.

These institutions that have arisen in the United States and the UK that combine hedge funds, equity funds, large proprietary trading with commercial banks, have enormous conflicts of interest. And I think the conflicts of interest contribute to their instability. So I would say let’s get rid of that. Let’s have big and small commercial banks and protect them – it’s the service part of the financial system.

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Funny, if you go back through those paragraphs and replace "United States" with "Iceland" you'd have a good description of what the three Icelandic banks (Landsbanki, Kaupþing, and Íslandsbanki (née Glitnir (née Íslandsbanki))) were and what they became.

All three started out (or had component pieces that started out) as good old fashioned banks. Banks that took customers' deposits and made loans to Icelandic enterprise with those deposits. Staid, boring, and with low profit margins. Then with the advent of the Roaring 00s and the globalization of Iceland's financial sector the three transformed themselves into multi-headed high-profit high-leverage monsters. They expanded internationally, making all kinds of fancy loans (to markets they maybe didn't understand all that well) in Europe and North America. They started their own equity hedge funds and currency speculation funds and private equity vehicles. They had their own proprietary trading shops that risked the bank balance sheet on equity deals, real estate deals, and foreign investments of all kinds.

And all this time, they each maintained extensive Icelandic branch networks, offered savings accounts and ATMs, issued credit cards, made small-business loans, and supported things like local soccer leagues. It was a strange juxtaposition: hedge funds on one side of the wall and take-a-number teller lines on the other. But in this they were miniature versions of international institutions like Citibank and HSBC.

This is why I feel Volcker's proposal here may also make some sense as a way forward for Iceland. Currently all three banks are in an ill-defined form of government receivership. There is ample scope for restructuring them now, in the way that makes the most sense for the future.

It would make sense to reconstitute the three of them as traditional commercial banks. These banks would be limited in their activities, and strictly regulated, to taking deposits and making loans to consumers and businesses. They would provide the kind of basic credit that is necessary to keep the economy moving. The parts of the old banks (now likely mostly worthless) that engaged in what Volcker terms "highly risky entrepreneurial activity" could be either shut down or sold off to domestic or foreign buyers.

In the interests of the Icelandic consumer (remember them?) I think it would then make sense to look for a stable foreign bank or banks to buy up one or two of the new "pure" commercial banks. In almost every industry, Iceland could benefit from competition, and banking is no exception. Foreign ownership by an experienced commercial bank would bring economies of scale to bear on the local market, providing cheaper banking services and better financing options, as well as bringing international standards of operation.

It's not too soon to begin looking forward to the future here, and to what kind of banking system would best benefit the Land. Applying Paul Volcker's proposal would be a good start.