PARIS – Last month, the European Commission unveiled its much-anticipated blueprint for banking reform, aimed at reining in risk-taking by the European Union’s largest banks. But the proposal has met significant resistance, with some warning that it would erode European banks’ competitiveness, and others arguing that it is inadequate to mitigate banking risks effectively. How this debate unfolds will have profound implications for the EU’s future.
According to Michel Barnier, the EU commissioner spearheading the reform effort, the proposed measures – including regulatory authority to divide banks’ riskier trading activities from their deposit-taking business, and a ban on proprietary trading by the largest banks – would enhance financial stability and protect taxpayers. But the draft regulation falls far short of the recommendations made by a high-level expert group in 2012, which included an impermeable wall between banks’ speculative-trading business and their retail and commercial banking activities.
Nonetheless, many claim that Barnier’s proposal goes too far. Perhaps the strongest reaction came from Bank of France Governor Christian Noyer, who called the proposals “irresponsible and contrary to the interests of the European economy.”
The positions taken in this complex debate do not align neatly with the traditional left-right political spectrum. Barnier is a center-right Frenchman recommending more public control over private banking activities. (Indeed, stricter banking regulation has been endorsed by all.) And, while Noyer’s position at the central bank makes him independent, he is championing banking-sector autonomy in a country led by a left-wing government. What is at stake is Europe’s capacity to avoid another financial meltdown – one that could be even more devastating than the 2007 crisis.
Of course, to some degree, a capitalist system will always be vulnerable to shocks and crises. The question is how to respond to them to minimize the fallout, while bolstering the system’s resilience.
In 1929, a crisis among speculating capitalists prompted poorly conceived and excessive reactions, leading to a deep and prolonged depression. Less than four years later, US President Franklin D. Roosevelt’s newly elected government passed the Glass-Steagall Act, which prohibited commercial banks from trading securities with clients’ deposits.
By forbidding investment banks from holding cash deposits, Glass-Steagall helped to support more than a half-century of financial stability after World War II. This – together with the gold exchange standard, which ensured that credit did not exceed the economy’s productive capacity – contributed to sustained global economic growth.
Everything changed in 1971, when US President Richard Nixon, unable to contain the fiscal deficit resulting from spending on the Vietnam War and expanded social-welfare programs, abolished the dollar’s direct convertibility to gold. The resulting exchange-rate, interest-rate, and commodity-price volatility continues to this day.
The financial sector has since made every effort to design instruments that protect against price fluctuations, to transform private debt into tradable financial securities, and to gain access to speculative markets. But these efforts were conducive to fraud and delinquency, and thus spurred a wave of new financial crises – in Europe in 1992, in Asia in 1997, and in Russia in 1998 – as well as a recession in Europe and the United States in the early 2000’s.
Two other destabilizing developments emerged in the last quarter of the twentieth century: a strong incentive to use debt to prop up demand, and a shift toward financing public debt through private institutions at market prices, under the pretext of fighting inflation. These trends boosted public-debt burdens, while flooding the global financial system with liquidity generated by private banking activities that were unconnected to transactions in the real economy.
As a result, by 2006, global liquidity amounted to more than twice the value of world GDP. Add to that the American financial sector’s untenable subprime and securitization activities, and it is not surprising that the next two years brought the global financial system to the brink of outright collapse.
To prevent the crash from triggering another Great Depression, governments intervened with massive taxpayer-funded bailouts, causing public-debt burdens to swell further, reaching unsustainable levels in many developed economies. Making matters worse, the US, the United Kingdom, and Japan began implementing quantitative-easing policies – that is, they began printing money – in an attempt to sustain GDP growth.
Through all of this, governments have strengthened bank regulation only slightly, leaving key issues like liquidity creation, exposure to derivatives, and tax avoidance largely unaddressed. Today, 98% of the $750 trillion in global liquidity is in speculative markets. Like all bubbles, this one is bound to burst.
The European Commission has acknowledged the danger, declaring that the only way to mitigate it is to separate the real economy from speculative markets by preventing banks from being involved in both. But, according to Noyer, such a move would not work in the eurozone, where banks’ profits depend largely on their risky activities. If those activities move to the UK, the eurozone economy will suffer considerably.
From a short-term perspective, Noyer’s position is largely correct. But the profits that would be lost remain lower than the potential costs of another major financial crisis. The eurozone’s member states should never again have to face such costs.