Boosting bank capital is not enough to avert crises

Anatole Kaletsky

“While everybody knows that major reforms are needed in the regulation of Britain’s financial system and last week’s White Paper represented a useful contribution to this debate, Mervyn King was right, if cruelly undiplomatic, when he pointed out that the main decisions on these issues would have to be taken after the next election, when another government might well be in power. In the Comment section last Thursday I explained five principles that should guide any redesign of Britain’s regulatory system.

First, finance is indispensable in any market economy and Britain has a clear comparative advantage in international finance. Regulations should, therefore, promote financial innovation, as well as economic stability.

Second, financial institutions are often driven by herd instincts and make catastrophic mistakes, which is why they need to be regulated.

Third, banks cannot be governed by the same accounting rules and transparency requirements as other businesses, because their main functions are maturity transformation and risk-spreading.

Fourth, government guarantees are indispensable in any efficient banking system and all banks in a modern economy are “too big to fail”.

Finally, banks’ risk-management is too important to be outsourced to private credit rating agencies, accountancy firms or even the banks’ own managers — regulators must also play an active part.

Now let me suggest some practical policies. First, Britain must veto attempts by the European Commission and the German and French governments to smother non-bank financial institutions with regulations triggered by the banking crisis. Continental finance is dominated by banks, but Britain has a competitive advantage in non-bank institutions: investment managers, hedge funds, brokers, private equity partnerships and so on. These diverse businesses generate much economic activity and tax revenue for Britain without creating the same systemic risks as banks. British governments must be prepared to block EU regulations that damage non-bank financial institutions. If necessary, Britain must use the ruthless tactics that France employs against agricultural reforms unwelcome to its farmers or that Germany uses against energy and climate rules detrimental to its motor and coal industries.

Second, increasing bank capital is necessary but not sufficient. Even more important than the bank re-capitalisation emphasised by Mr King throughout the crisis and finally imposed last October, is reform of liquidity management. This has been suggested by the FSA, but largely ignored by the Bank of England. The surest way to prevent future liquidity crises such as Northern Rock is to force all banks to invest a high proportion of their assets in cash, Bank of England deposits or Treasury bills. In the past, cash and deposit requirements and even supplementary special deposits (also known as “corsets”) were major tolls for managing bank liquidity and also to regulate the credit cycle. But all such liquidity requirements were gradually abandoned under pressure from the banks, which naturally preferred to invest depositors’ money in riskier and higher-yielding assets.

As a result, British banks have generally kept far less money in safe and liquid assets than banks elsewhere. In the past few months, this situation has changed. In 2006, the sum of circulating cash plus bank reserve deposits in the UK economy was only 5 per cent of GDP — compared with 6.5 per cent in the US, 9 per cent in the eurozone and 17 per cent in Japan. But since the Bank’s recent “quantitative easing” programme, Britain’s liquidity level has shot up to 13 per cent of GDP, similar to the US and eurozone (see chart). If such a level of liquidity were permanently mandated, future financial crises would be averted — and the Treasury would gain about £3 billion a year in “seignorage revenue” (or save that much in debt payments on the corresponding amount of government bonds). This £3 billion would effectively be a stealth tax on banks and borrowers. But in the present political climate, that must be an argument in favour of such a liquidity rule.

Third, accountants must abandon the quixotic idea of forcing banks to value their assets in the same way as other businesses. Because banks are in the business of maturity transformation, their assets will always be longer term and less liquid than their liabilities. If banks are forced to mark their assets “to market values” on a quarterly basis, instead of smoothing out the maturity mismatch, most will appear insolvent most of the time.

Fourth, governments must make clear which bank liabilities are guaranteed. Many regulators, central bankers in particular, still believe that explicit bank guarantees create “moral hazard”. They also claim that governments keep investors on their toes with “constructive ambiguity” about which bank liabilities might enjoy taxpayer support. These views have been discredited by the financial crisis. Whenever governments left any doubt about which bank liabilities were protected, they ended up offering guarantees to all creditors in all banks. “Constructive ambiguity”, far from saving taxpayer money, has proved the greatest source of moral hazard.

This experience refutes Mr King’s call to overcome moral hazard by breaking up banks that are “too big to fail”. Breaking up some banking dinosaurs may well be sensible, for reasons of competition and managerial efficiency. But it is a delusion to suggest that any bank can ever be allowed to renege on depositors or senior creditors. The right answer is to define in advance which bank obligations will enjoy 100 per cent guarantees, preferably funded by the banks themselves, but backed by the government. Only by offering explicit guarantees and by casting the safety net wide enough to cover all deposits and senior credits, will regulators be credible when they deny government banking for other bank liabilities — equities, preferred shares, unsecured bonds and so on. The binary risks of bank liabilities — either totally guaranteed or not guaranteed at all — should be made even clearer by a drastic simplification of balance-sheets.

Ideally, banks should have just two kinds of liabilities: deposits or senior bonds of various maturities, which should be 100 per cent safe, and pure equity, which should bear the entire risk of credit losses and liquidity mismatches. By draining the alphabet soup of “hybrid” capital structures that exploit ambiguities about the true risks of bank liabilities, regulators could remove one of the main causes of last year’s crash.

Finally, governments must insist that bank solvency calculations and reserve policies are based on prudent and appropriate macroeconomic models and assumptions. Private credit-rating agencies do not have the skills, the credibility or the independence to do this job. Regulators and central banks should therefore impose a consistent and objective macroeconomic framework on all the banks’ prudential calculations, for example deciding what assumptions on house prices, unemployment and economic growth are incorporated in bank risk models.

Most of the ideas above would be strongly resisted by banking lobbies. But, as in the case of my proposal for a bank-liquidity “stealth tax”, politicians may conclude that any measure opposed by bank lobbies has something to commend it.” (Anatole Kaletsky, The Times)


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