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The pound and European markets took big hits when the United Kingdom voted to leave the EU. Economics correspondent Paul Solman talks to Mervyn King, the former head of the Bank of England and the author of “The End of Alchemy,” who offers a longer view -- and a less alarmed one -- about what Brexit means for global banking and financial stability.
But, first: It has been a rough couple of weeks in Britain since the country voted to leave the European Union. The pound dropped to its lowest levels in more than three decades, and the European markets have taken hits over concerns about the economic impact.
Tonight, we get a longer view, and a less alarmed one, about what it means for global banking and financial stability.
Our economics correspondent, Paul Solman, filed this report from across the pond. It's part of his weekly reporting on Making Sense of financial news.
Mervyn King, former head of the Bank of England.
In his new book, "The End of Alchemy," King still worries that the world banking system hasn't reformed itself, eight years after its excesses led to collapse.
MERVYN KING, Former Governor, Bank of England: Thames, the old man river of Britain, been here forever, rather like money and banking. We have always had them.
As it happens, he was giving me a tour of London to make his case on the day of the Brexit vote. The oddsmakers, the markets, and I at least thought Britain would remain in the E.U. As we passed a group of upbeat remainers, I thought, no problem.
Counting is under way of tens of millions of votes.
Then came the result.
And the answer is, we're out.
(CHEERING AND APPLAUSE)
So, before asking you to take the tour, we checked back with King to see if the vote had altered his analysis.
We didn't talk much about the Brexit vote, because actually the Brexit vote isn't germane to the fundamental challenges dealing with our banking system and putting it on a sound footing. We were talking as we walked around London about the really important long-run issues affecting our economies.
Look, King says, when you take the long view, the global financial system needs the same fixes it did before Brexit. He believes his tour of London finance, therefore, is as relevant as ever.
This is Lombard Street, the title of Walter Bagehot's great book in the 1870s about how to ensure that banking crises don't occur or how to respond to them. And this was the place where finance houses were situated, the early coffee houses which turned into banks and trading houses and the heart of the city of London.
And his idea was that people who worked here would just be able to walk across the street to the Bank of England, give the security, the collateral they had to the Bank of England. The bank would lend them money. They'd rush back and pay off the creditors and depositors who wanted their money back.
Central banks exist to be lenders of last resort. Problem: Too big to fail. And that's what began happening in England, just like America, in the '80s and '90s.
Here we are now in the modern Docklands area. So this is where the banks came to trade, all the derivative instruments, CDO-squared, all the complex instruments. They were traded down here.
And is a large part of the problem that crystallized in the crash of '08, because people like yourself, the Bank of England, the Fed in the United States couldn't keep up with the innovation that was going on in places like this?
I would put it differently. I think there were two things that were going on. One was that, because interest rates were falling throughout the world, asset prices were rising, trading looked very profitable, and, therefore, the leverage of the banking system rose very sharply.
Leverage, meaning the ratio of the bank's own money to the money it borrows in the form deposits or short-term loans.
So, that made the banking system more fragile. The other thing was that what proved very difficult — and it's always going to be very difficult — is that businesses or particular methods of financial services that keep making money year after year, are they making money because they are just good ideas and they are very successful, or are they making money because they are very risky and are just on the edge?
But people must've realized that was happening, so how come regulation didn't adapt to the changing environment?
It's easy with hindsight to look back and say, oh, these regulations turned out to be inadequate, because it turned out the mortgage lending, for example, was riskier than was thought beforehand. But that's the problem of thinking in advance that you have got a detailed system that works, and then you think, oh, that will work. Then you discover it doesn't.
And you do need something much more robust and much more simple to prevent, I think, the same problem from happening again.
So King has two proposals for preventing another crash.
So, this now is the Bank of England. This is the building which has been the home of the Central Bank since the early 18th century.
And this is where you were in 2008?
Yes, I was on the ground floor, because the governor's office is on the ground floor. And this is where the banks would come in to meet with us regularly and when they came in to say, we need a lot of money.
And the whole point of your book…
Is to make sure that we don't have as frequent or as damaging a banking crisis as we saw in 2008.
King's first proposal is that banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
So that, when there is a run on the bank and depositors lose confidence, for whatever reason, it is perfectly acceptable for the Central Bank to pay the cash to the banking system as a short-term loan.
King's second proposal is also simple: Force the banks to keep enough cash on hand to cover loans gone bad.
Banks didn't have enough equity finance.
So, when you say equity, you mean the cushion of the bank's own money?
Yes, the shareholders' own funds, which are available to be able to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.
When a bank fails to be able to return money to its depositors or other people from which it's borrowed, then the bank fails, and you get into a problem of potential default.
The last question I asked King the day of the Brexit vote was this: In how much danger is the world banking system at the moment? On a scale of 1-10, I added.
So, it depends on the time scale.
I think, in terms of the current, immediate problems, you know, only three, four or five. But if you were to say to me, do I think we are going to avoid a serious problem in the next decade, then I think the answer is probably not. That is much more like seven or eight.
And does he still give the same scores, now that the U.K. has voted to exit the E.U.?
I don't think the vote makes any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy. But I really don't think that the Brexit vote itself really makes any significant difference.
As, he adds, it may not make any significant difference to the long-term future of Europe's economies, despite the chop in the currency and stock markets at the moment.
Economies have a habit of being pretty resilient in the longer run. When people and countries want to trade with each other, they find ways to do so. And I'm sure that will happen now.
This is economics correspondent Paul Solman, reporting from the U.K., and now from back in the U.S. of A.
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