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Five years after the greatest financial crash in history, the banks are still creating chaos

Felix Martin's "Real Money" column.

Banking institutions are more dangerous than standing armies,” wrote Thomas Jefferson in 1816. The president of Cyprus, Nicos Anastasiades, has just joined the growing line of European politicians who have come to the same conclusion. Cyprus is the latest European country to be brought to its knees by its banks. It is time governments started thinking more seriously about why this is the case and what should be done about it.

Cyprus’s is a story with more angles than Euclid’s Elements, from its unfinished civil war and its strategic naval bases to its status as Russia’s own private Channel Island and its prodigious untapped gas reserves. But the essence of the current crisis is all too simple. Cyprus has big banks: seven times the size of its economy, at the last count. These big banks have a big problem. Their assets, the loans they have made and the bonds that they own, are not worth what they thought they were. The reason could hardly be more ironic. In 2012, their portfolios included a lot of Greek bonds. When Greece pulled off its EU-approved default, they had to swallow a loss of about 75 cents in the euro.

Now if you or I had owned Greek bonds, we would have owned them outright. We’d have lost our shirts in the default but that would have been that. Banks, however, are not like you or me. They fund the assets they own by issuing their own bonds and by taking deposits. They have fixed liabilities, in other words – a lot of them. So when they are forced to book a large and unexpected loss, there is a problem. All of a sudden, their liabilities are larger than their assets. Their balance sheet does not balance. Barring external support, they are bust.

What should be done when big banks go bust? The purist’s answer is that they should be placed in bankruptcy just like any other company. Those who provided capital to the failed bank would take losses according to the legally mandated order of precedence. Equity shareholders lose out first. If the losses are more than the bank’s equity alone can absorb, those who have provided capital by buying its bonds or making large-scale deposits must also take a hit. The only people whose money is safe even if the bank’s assets shrink to zero are its small depositors, for whom statutory insurance will save the day.

This purist’s approach is, on the face of it, the only fair one. After all, why should taxpayers bail out a bank’s shareholders, bondholders, or wealthy depositors if something goes wrong? It was the strategy adopted by Iceland, another country with a hypertrophied banking sector, in the face of its financial crisis in 2008. Rather than bail out its banks, Iceland liquidated them. The shareholders were wiped out. Small depositors were paid out from the good assets. The bondholders were left to wring what they could from the bad ones.

Other countries opted not to be purists, though, as we in Britain know only too well. In early 2008, our government also issued solemn warnings that taxpayer bailouts would wreck financial discipline. When it became clear that three of Britain’s largest banks were insolvent, however, our leaders realised that things were a little more complicated. The big banks are important British employers, exporters and taxpayers. What’s more, the rest of the economy depends on them for credit and payments. Allowing the big banks to fail would be sacrificing Britain’s economic future on the altar of an abstract financial ideal. Bankruptcy was out of the question.

Instead, it was bailouts all round, and all on the taxpayer. The partial nationalisation of RBS and Lloyds obliged shareholders to take a hit but bondholders and depositors were left untouched. The rationale was to minimise the loss to the British taxpayer. Nationalisation would certainly cost money; but the cost in lost growth and lost tax revenues if bank bankruptcies had been permitted would have been even worse. Pragmatic macroeconomic reality trumped noble financial principle.

Such is the context of Cyprus’s plight. The German government and the International Monetary Fund argued in favour of the purist’s approach. The fair thing to do is to stick to principles and liquidate the banks: Cyprus should become a second Iceland. The Cypriots, meanwhile, would have preferred to become another Britain, and so preserve their flagship industry and avoid economic oblivion. On Sunday 24 March, the Icelandic approach prevailed. Negotiating an EU bailout is a game that lasts a few tortuous weeks, and then the Germans win.

Being the purist’s solution, it will be scrupulously fair – and economically disastrous. Cyprus will be finished as a financial centre, its people can look forward to a deep recession from which there will be no swift recovery, and those who hold its sovereign debt can start worrying about a default and restructuring in a couple of years. But for the time being, victory can be declared and we can all be told to continue on our way, because there is nothing more to see.

These plot details of the latest episode of the eurozone soap opera starring the selfstyled model states of northern Europe and the mañana republics of the south are mostly a distraction, however. The real disaster exposed by the Cyprus debacle is that five years after the greatest financial crash in history, neither the EU nor any other jurisdiction has done anything serious to fix the structure of its own banking system. We remain lumbered with banks so large and complex that sticking to fair principles and winding them up when they are bust is self-defeating. It is a poisonous recipe for perpetual bad faith. There has been enough argument about how to treat the symptoms. Cyprus is a reminder that the time has come to treat the disease itself.

Felix Martin is a macroeconomist and bond investor. His book, “Money: the Unauthorised Biography”, is out in June

Macroeconomist, bond trader and author of Money

This article first appeared in the 01 April 2013 issue of the New Statesman, Easter Special Issue

Photo: Getty Images
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What's to be done about racial inequality?

David Cameron's words on equal opportunities are to be welcomed - now for some action, says Sunder Katwala.

David Cameron made the strongest, clearest and most high profile statement about ethnic inequalities and the need to tackle discrimination ever yet offered by a British Prime Minister in his leader’s speech to the Conservative Party conference in Manchester.
“Picture this. You’ve graduated with a good degree. You send out your CV far and wide. But you get rejection after rejection. What’s wrong? It’s not the qualifications or the previous experience. It’s just two words at the top: first name, surname. Do you know that in our country today: even if they have exactly the same qualifications, people with white-sounding names are nearly twice as likely to get call backs for jobs than people with ethnic-sounding names? … That, in 21st century Britain, is disgraceful. We can talk all we want about opportunity, but it’s meaningless unless people are really judged equally”, said Cameron.
While the proof of the pudding will be in the eating, this was a powerfully argued Prime Ministerial intervention – and a particularly well-timed one, for three reasons.

Firstly, the Prime Minister was able to root his case in an all-but-universally accepted appeal for equal opportunities. It will always prove more difficult in practice to put political energy and resources behind efforts to remedy discrimination against a minority of the population unless a convincing fairness case is made that values cherished across our whole society are at stake. Cameron’s argument, that any party which tells itself that it is the party of the ‘fair chance’ and ‘the equal shot’ must have a response when there is such clear evidence of discrimination, should prove persuasive to a Conservative Party that has not seen race inequalities as its natural territory. Cameron argued that the same principles should animate responses to discrimination when it comes to race, gender and social class. Put like that, wanting job interviews to be fair – by eradicating conscious and unconscious patterns of bias wherever possible – would strike most Britons as offering as clear a case of the values of fair play as wanting the best baker to win the Great British Bake-Off on television.
Secondly, Cameron’s intervention comes at a potential "tipping point" moment for fair opportunities across ethnic groups. Traditionally, ethnic discrimination has been discussed primarily through the lens of its impact on the most marginalised. Certainly, persistent gaps in the criminal justice system, mental health provision and unemployment rates remain stark for some minority groups. What has been less noticed is the emergence of a much more complex pattern of opportunity and disadvantage – not least as a consequence of significant ethnic minority progress.

Most strikingly of all, in educational outcomes, historic attainment gaps between ethnic minorities and their white British peers have disappeared over the last decade. In the aggregate, ethnic minorities get better GCSE results on average. Ethnic minority Britons are more likely, not less likely, to be university graduates than their fellow citizens. 

As a result of that progress, Cameron’s intervention comes at a moment of significant potential – but significant risk too. Britain’s ethnic minorities are the youngest and fastest-growing sections of British society. If that educational progress translates into economic success, it will make a significant contribution to the "Great British Take-Off" that the Prime Minister envisions. But if that does not happen, with educational convergence combined with current ‘ethnic penalties’ in employment and income persisting, then that potential could well curdle into frustration that the British promise of equal opportunities is not being kept.  Cameron also mirrored his own language in committing himself to both a ‘fight against extremism’ and a ‘fight against discrimination’: while those are distinct challenges and causes, actively pursuing both tracks simultaneously has the potential, at least, depolarise some debates about responses to extremism  - and so to help deepen the broad social coalitions we need for a more cohesive society too.

Thirdly, Cameron’s challenge could mark an important deepening in the political competition between the major parties on race issues. Many have been struck by the increase in political attention on the centre-right to race issues over the last five to ten years. The focus has been on the politics of representation. By increasing the number of non-white Conservative MPs from two to seventeen since 2005, Cameron has sent a powerful signal that Labour’s traditional claim to be ‘the party of ethnic minorities’ would now be contested. Cameron was again able to celebrate in Manchester several ways in which his Cabinet and Parliamentary benches demonstrate many successful journeys of migrant and minority integration in British society. That might perhaps help to ease the fears, about integration being impossible in an era of higher immigration, which the Home Secretary had articulated the previous day.

So symbolism can matter. But facial diversity is not enough. The politics of ethnic minority opportunity needs to be about more than visits to gurdwaras, diversity nights at the party conference fringes and unveiling statues of Mahatma Gandhi in Parliament Square. Jeremy Corbyn’s first speech as Labour leader did include one brief celebratory reference to Britain’s ethnic diversity – “as I travelled the country during the leadership campaign it was wonderful to see the diversity of all the people in our country” – and to Labour bringing in more black, Asian and ethnic minority members - but it did not include any substantial content on discrimination. Tim Farron acknowledged during his leadership campaign that the Liberal Democrats have struggled to get to the starting-line on race and diversity at all. The opposition parties too will no doubt now be challenged to match not just the Prime Minister’s rhetorical commitment to challenging inequalities but also to propose how it could be done in practice.

Non-white Britons expect substance, not just symbolism from all of the parties on race inequalites.  Survation’s large survey of ethnic minority voters for British Future showed the Conservatives winning more ethnic minority support than ever before – but just 29 per cent of non-white respondents were confident that the Conservatives are committed to treating people of every ethnic background equally, while 54 per cent said this of Labour. Respondents were twice as likely to say that the Conservatives needto do more to reach out – and the Prime Minister would seem to be committed to showing that he has got that message.  Moreover, there is evidence that ethnic inclusion could be important in broadening a party’s appeal to other younger, urban and more liberal white voters too – which is why it made sense for this issue to form part of a broader attempt by David Cameron to colonise the broad centre of British politics in his Manchester speech.

But the case for caution is that there has been limited policy attention to ethnic inequalities under the last two governments. Restaurateur Iqbal Wahhab decided to give up his role chairing an ethnic minority taskforce for successive governments, unconvinced there was a political commitment to do much more than convene a talking shop. Lib Dem equalities minister Lynne Featherstone did push the CV discrimination issue – but many Conservatives were sceptical. Cameron’s new commitment may face similar challenges from those whose instinct is to worry that more attention to discrimination or bias in the jobs market will mean more red tape for business.

Labour had a separate race inequalities manifesto in 2015, outside of its main election manifesto, while the Conservative manifesto did not contain significant commitments to racial inequality. The mid-campaign launch in Croydon of a series of race equality pledges showed an increasing awareness of the growing importance of ethnic minority votes - though the fact that they all involved aiming for increases of 20 per cent by 2020 gave them a slightly back-of-the-envelope feel. 

Prime Ministerial commitments have an important agenda-setting function. A generation ago the Stephen Lawrence case opened the eyes of middle England to racist violence and police failures, particularly through the Daily Mail’s persistent challenging of those injustices. A Conservative Prime Minister’s words could similarly make a big difference in the mainstreaming of the issue of inequalities of opportunity. What action should follow words? Between now and next year’s party conference season, that must will now be the test for this Conservative government – and for their political opponents too. 

Sunder Katwala is director of British Future and former general secretary of the Fabian Society.