Blog

Too many lifeboats

15/03/2011

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

When, 99 years ago next month, the Titanic sank with the loss of 1,517 lives, numerous investigations were undertaken into how and why, yet very little legislation came about as a result. One exception was a regulation requiring every vessel to carry sufficient lifeboats to evacuate all passengers and crew – an issue that, even if it contributed to the loss of life, hardly led to the Titanic colliding with the iceberg.

Two years later, the SS Eastland, a passenger ship on the great lakes with a top-heavy design made even more unstable by the recent addition of a large number of lifeboats, capsized while docked on the Chicago river with 844 lives lost – a tragedy directly attributable to the legislation enacted after the Titanic sank.

This is an admittedly bleak illustration of how legislators can, on occasion, not only focus on the by-products of an issue rather than the cause but also produce laws with unanticipated but significant consequences – something the bank regulators of today would do well to bear in mind.

With the financial crisis still fresh in their memory, people perceive the banking sector to be risky but, given the levels of capital they have had to raise since, banks arguably carry less risk than they did three years ago. Furthermore, irrespective of the level of risk involved, legislators should not try to stop a bank from taking risks because otherwise they will not fulfil their primary function of lending money.

Banks must take risk to lend, but they must lend prudently and this leads to a second point – banks should not be set lending targets, otherwise we are right back to how the financial crisis began in the first place, loans being made with insufficient emphasise on risk. Whenever banking commissions meet, regulations are passed and capital requirements are set, there is always the danger of adding too many lifeboats.

Banking is inherently a risk-taking business and needs to be treated as such, with pay, incentives, regulations and so forth structured to achieve a balance between risk and reward. Legislators cannot allow a situation where banks benefit from taking risks but are bailed out if things go wrong. Equally, however, they cannot allow a return to the Victorian approach of unlimited liability for bank shareholders as that inevitably sees lending dry up.

Nor should they be sidetracked by issues that did not actually cause the banking crisis, such as size – HSBC the world’s biggest bank has survived unscathed while many smaller banks have not – or splitting up retail and investment operations – Northern Rock, one of the first casualties of the crisis, was a common or garden mortgage lender. The central issue is fundamentally one of culture and ensuring there is an equal burden borne by both a business’s shareholders and its risk-takers.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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