W hen bankers mess up – and it is reckless behaviour by banks that now threatens us with a credit crunch and even a recession – they quickly turn to governments to bail them out.
These masters of the universe are now on a diet of humble pie, although those at the top who are to blame still get huge multi-million-dollar severance packages when they leave and keep past bonuses we can now see were unjustified.
At least in Canada our bankers seem like Boy Scouts compared with what we see on Wall Street or in the City in London.
Central banks in the United States and Europe have had to flood financial markets with tens of billions of dollars to bail out financial institutions, and the big writedowns are not over yet. Bankers are also begging central banks to lower interest rates to keep their ships afloat. The Bank of Canada is expected to cut its key rate on Tuesday and the U.S. Federal Reserve on Dec. 11.
Banks play a unique role in the economy. They are much like public utilities – they act as repositories of our savings, allocators of credit to businesses, and consumers and managers of the payments system.
Governments support banks by giving them ready access to loans from central banks to balance their own books and by operating a system of deposit insurance so individuals have confidence their deposits are safe. Major banks also operate on the assumption governments can't afford to let them fail because of their essential role.
But at the same time, banks are profit-seeking businesses, and their top executives are generously rewarded with multi-million-dollar compensation packages for high performance.
So bankers have a problem. They must operate under rules designed to make them act prudently. But big profits may come from acting less prudently.
These rules, though, only apply to the balance sheets of banks. So banks and their executives have pursued off-balance-sheet activities such as various collaterized debt obligations for which they earn huge fees and escape the eye of regulators. Moreover, because banks make loans but then sell them to other investors, lending standards may be relaxed.
This is the root of the current crisis. U.S. banks made hundreds of billions of dollars of so-called subprime loans to home buyers who had questionable capacity to repay and under prudent loan practices would not have obtained mortgages.
But now, as these mortgages face new terms, many borrowers cannot maintain payments. Housing prices are in a nosedive and foreclosures are on the steep upswing.
A large proportion of these mortgages were packaged into dubious investment vehicles and sold to foreigners, including Canadians, backed by triple A ratings from U.S. rating agencies. This meant, says Stephen King, chief economist of HSBC, that "the rest of the world has funded the expansion of the U.S. housing market through increased purchase of assets that are, in many cases, now seen to be not much more than toxic waste."
Ordinary people around the world will now pay a high price for this recklessness and greed of bankers. The credit crunch will reduce their ability to borrow, and we face a possible recession that could cost their jobs.
As Larry Summers, the former U.S. Secretary of the Treasury, warns, "the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is increasingly in doubt." Banks must rebuild their own finances after major writedowns and are now risk-averse.
Clearly, we need a better way of regulating the financial system to give much greater transparency to risks and to change the incentive system so that bankers are not driven by a readiness to bend corners for greater personal wealth.
David Crane's column on Global Issues appears Sundays.