New U.K. Bank Reforms Miss the Big Threat

Simon Johnson, who is a professor at MIT's Sloan School of Management, is co-author of "White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You."
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The U.K.'s Parliamentary Commission on Banking Standards published a report this morning - almost 600 pages in two weighty volumes -- focused on "changing banking for good."

There are many sensible ideas here, including "making senior bankers personally responsible, reforming bank governance, creating better functioning and more diverse markets, reinforcing the powers of regulators and making sure they do their job." And there are some entirely reasonable specific suggestions such as "The Chief Risk Officer, Head of Compliance and Head of Internal Audit should all have their independence protected, responsibility for which should lie with a named non-executive director."

If these measures were proposed for any other industry, everyone would nod in agreement and get on with the hard work of implementation. But this is the financial sector, and we should look forward to a huge amount of pushback, counter-reports from purported independent research groups and a flood of misinformation intended to delay any real change.

The bigger problem is that, for all its good intentions, the parliamentary commission missed the main point. The reason that incentives have become so distorted and behaviour so bad in some parts of the U.K.-based financial sector -- remember Libor? -- is simple. U.K. banks have been allowed to operate with very low levels of equity capital and huge amounts of debt relative to their balance sheets.

Consider Barclays Plc . It has about 97 cents in debt for every dollar of assets, or just 3 cents of equity in a position to absorb potential losses. I'm not talking about the situation in 2007 or 2008 -- when the global financial system stood on the brink of collapse -- this is the reality today.

It is incomprehensible to me that such a distinguished group of U.K. politicians would almost entirely neglect capital requirements as a key reason why bank employees seek high return on equity, and take huge risks. When things go well, they are well compensated, and we will never properly risk-adjust the basis for their compensation. When things go badly, the U.K. taxpayers and the broader economy take the hit.

I appreciate the effort that went into preparing this parliamentary report. And I wish its authors well in the coming battle with representatives of the financial sector.

But this is Hamlet without the prince.

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