Jeremy Warner's Outlook: Banks invite fierce regulatory backlash

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The Independent Online

Yikes. I warned last Saturday that the crisis in financial markets was about to enter a new and more dangerous phase, with further big writedowns and recapitalisations to come in America and in Europe, but I hadn't figured on the degree of carnage that was unveiled first by Citigroup and now Merrill Lynch.

More worrying still, far from regarding these losses as "kitchen sinking" that would draw a line under the meltdown in mortgage-backed securities, markets have chosen to see them as the start of something much more serious, requiring serial bail-outs and possibly culminating in a serious recession.

The detail of the Merrill Lynch results makes shocking reading. Fourth-quarter losses after massive write-offs on mortgage-backed securities were a staggering $9.8bn (£5bn), wiping out all the gains of the boom conditions of the first half and plunging the investment bank into deep losses for the year as a whole.

The new chief executive, John Thain, appears to have been ultra conservative in the degree of impairment charge he's applied, with debts marked down to no more than their likely income generation, but he was unable to guarantee that this will be the end of it.

Merrill Lynch was a Johnny-come-lately to the sub-prime party, with its previous chief executive, Stan O'Neal, encouraging his traders to run higher risk positions than had been the norm in a Wall Street name known for its conservatism and stuffiness. The consequent lack of discipline and controls produced an entirely predictable outcome.

Mr Thain, a former chief operating officer at Goldman Sachs, insists that never again will traders be allowed to take on positions that could wipe out the entire organisation. It is only because of rescue finance from the Middle East and Asia that the broking house is still standing at all.

The irony of these bailouts is one of the most striking features of the unfolding credit crunch, with once-proud symbols of American capitalism forced to pass round the begging bowl to the sovereign wealth funds of the developing world.

Yet they are also just the visible culmination of a much wider process of support for the affluent West by the developing world. For some years now, the vast capital surpluses of Asia and the Middle East have been underwriting the low interest rates and credit-fuelled economies of the Anglo-Saxon nations. It is a funny old world that has some of the poorest countries funding the consumption of some of the richest, but that's been the way of it. Now they are also being asked to prop up our busted banking system.

Not all the blame for the present crisis can be pinned on Wall Street and City bankers. Its underlying causes are many and varied. Yet the bonus-driven culture of investment banking, and the massive incentives it provides for the pursuit of extreme financial risk, is certainly a large part of the mischief. Bizarrely, the bonuses – some of them beyond the wildest imaginings of ordinary people – continue, with the limousines waiting at the back door to ship out the newly injected rescue capital even as it comes in at the front.

Mr Thain explains it thus. Even though the bank as a whole made a whacking great loss, some parts of it were highly profitable (no doubt working up the so far unsuspected financial crises of the future), and if they don't get their bonuses, they'll simply up shop and move elsewhere, leaving Merrill's a busted flush.

That may indeed be the reality, but if the excesses of investment bankers succeed in pushing us all into a deep recession, they can expect an extreme political and regulatory backlash which will affect all aspects of their business, including pay.

As is already depressingly apparent, banks cannot be allowed to fail, even though many of us might like to see them get their comeuppance. Their central position in the payments system, the loans they provide to individuals and companies, and the deposits for which they act as custodians, ensure that they have to be treated differently.

The support being provided by British taxpayers to keep Northern Rock alive is only the visible tip of a much bigger banking lifeboat being operated by central bankers throughout the developed world, with massive injections of liquidity and interest rate cuts far deeper than are justified by the quite ugly outlook for inflation.

Politicians on both sides of the Atlantic have been arguing that the quid pro quo for this support should be a higher degree of public accountability and regulation. Wilder voices are already demanding a complete reversal of the 30-year process of deregulation in capital markets.

In the thick of the crisis, it becomes hard to resist these arguments, yet two points seem worth making. The first involves practicality. Try to regulate what Goldman Sachs pays its employees in London and the company would simply up sticks and move to Paris or Beijing, which would welcome the influx of aspiring young masters of the universe with open arms. Even in a utopian world of globally regulated banking pay, the top talent would leave and start afresh outside the regulatory net. Whatever regulators do, it is part of the ingenuity of markets that they always manage to remain one step ahead.

The other point is the one made earlier this week by Sir Howard Davies, former chairman of the Financial Services Authority, that it is almost always a bad idea to construct policy in a crisis. Regulation designed in haste is invariably repented at leisure as the law of unintended consequences sets in. By seeking to make our banking system immune to future crises, we would only dramatically increase charges and stifle financial innovation.

Each financial crisis is different, with the iniquities of the dotcom bubble of seven years ago now more than matched by the excesses that have taken place in credit markets. The common thread is the greed of bankers, yet it is hard to know what can be done about it other than dusting off our Das Kapitals and storming the marble-clad banking halls of the City and Wall Street.

Markets are self-correcting, so the searing experience of the present crisis will imprison and neuter the investment bankers far more effectively than ever the politicians can.

Yet memories are short in the capital markets. The trick is to make your pile in a single business cycle and then retire to the country with the labradors. Wisdom is in short supply. Eventually a new boom will follow the bust. Everyone will again say, "this time it's different", and regulators will again sit on the sidelines as the investment bankers earn their millions, not wishing to spoil a party in full swing.

S&N outbluffs its Continental bidders

Well done John Dunsmore, the chief executive of Scottish & Newcastle. It was high-risk stuff, particularly in these markets, when he refused to talk to Carlsberg and Heineken at 780p a share. If they'd walked, the share price would have plummeted, but he appears to have outbluffed them. Now they've agreed to talk at the minimum 800p a share the S&N board was demanding.

What's more, they've agreed to allow S&N to publish information on the prized, jointly owned Baltic Beverages Holdings, so if anyone else, such as Anheuser Busch, wants to go playing Russian roulette, they'll have all the data they need. The door is thus left open to rival bidders. There is, of course, many a slip, but at this stage it looks as if Mr Dunsmore has played a blinder and extracted a very decent price.

Mr Dunsmore is new to the job of chief executive and would certainly have liked a longer go at it. Yet though he continues to think the company worth even more, he'd be stretching the loyalties even of his most committed long-only investors by further resisting. It is one of those regrettable features of the way the capital markets work that in a bear market, fund managers will snatch at anything that rescues their quarterly performance figures. S&N is one of the few bright spots in the stock market right now, and they are not about to let that one turn red too.

j.warner@independent.co.uk

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