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https://www.ft.com/content/b13dc90c-a75a-11e7-ab55-27219df83c97
Financial & markets regulation
Banking systems remain unsafe Premium
Keep raising capital requirements until they manifestly slow down growth
OCTOBER 2, 2017 by Martin Sandbu
A rather worrying consensus emerged in a recent conference held by the Centre for Economic Policy Research, in which top names from the economics profession (their presentation materials are available on the conference web page) assessed the state of the financial system 10 years after the crisis.
The consensus was that we still fall far short from what would be a safe financial system. There were worries about what could cause a new crisis (including the fear that financial technology could fail or be hijacked) and about risky activities migrating towards an unregulated shadow banking sector.
There was also a recognition that precious little structural reform of financial activity has taken place since the crisis. But as Ferdinando Giugliano has described, the most striking observations had to do with banking and the degree to which they have been made more robust against losses.
Or rather not been made robust enough. For as John Vickers pointed out, “the general . . . opinion among economists outside the financial sector is that banks should be required to have at least twice as much equity capital . . . as the prevailing regulatory settlement”, but “regulators, not just banks, [think] that reform since 2008 has got us to about the right place”.
Martin Wolf sums up the economists’ consensus in a recent op-ed, where he advocates equity requirements four to five times higher than today’s rules.
Those with the power to make this happen want none of it, it seems. Vickers has strongly criticised the Bank of England for its judgment that the required push for more equity funding in banks is largely completed. (To be fair, the BoE is also adding requirements for non-equity funding that can be “bailed in” to bear losses in a crisis.) Across the Atlantic, the US Treasury department has plans under way to weaken rather than strengthen capital requirements — plans that, in William Cline’s analysis, could cost the US economy $2.7tn in increased risks over 10 years.
The CEPR conference discussions raised some important principles to keep in mind that should guide our deliberations about how much of shareholders’ own money — which is what equity capital is — should be put behind a banks’ lending and investments. And they all point to the conclusion that higher requirements are better.
First, “equity” is an accounting construct. In Vickers’s phrasing, a bank’s equity is “the difference between the estimated value of its loan assets and other exposures on the one hand, and its contractual obligations to depositors and bondholders on the other. In short, it is a residual, the difference between two typically big numbers.” A small difference between two large numbers is highly sensitive to even small changes in those big numbers — assets and liabilities — and so it is in the nature of equity to be poorly measured and unstable.
Second, the way it is constructed means the inherent instability of measured bank equity is unstable in just the wrong way. Paul Tucker, the former BoE deputy governor, has explained this in a rather chilling, if technical, speech. Before the crisis, he says, “‘common equity’ was measured without adjustments for items recorded by accountants as assets but which don’t — can’t — help in a crisis”, such as “goodwill” (the assumed extra value acquired when assets are taken over for more than their prior accounting value) or future tax credits.
That means improvements in regulations made to sound impressive — Vickers highlights BoE governor Mark Carney’s point that equity requirements are 10 times higher than before the crisis — are true only because of how absurdly low the requirements were then. In Tucker’s calculation, “when tangible common equity is measured in a way that is more fit for purpose, the minimum risk-asset ratio requirement was about 1 per cent” and even less when not discounting supposedly safe assets with low risk-weights (which has its own problems). Consequently, the ability of banks today to have assets 25-30 times as large as the equity intended to absorb losses on them is only 10 times stricter than before the crisis because they could then get away with gearing up their own (their shareholders’) money by three-digit multiples. Vickers is surely right that “10 times better than hopelessly lax is not a useful measure”.
Finally, we should note that there are good reasons for paying particular attention to banking, even though financial risk can build up outside of banks too. One reason is that for all the talk about “shadow” banks — non-banks borrowing short-term and lending long-term like banks do — only banks have a literal licence to print money. Another is that the sort of lending they are particularly invested in — mortgage housing finance to households — turns out to be the single most dangerous type of finance for sustainable economic growth, as OECD chief economist Catherine Mann pointed out in her conference contribution.
What does all this point to? Leave aside the technical work overwhelmingly concluding that equity requirements should be stricter. Informed but lay citizens can hardly determine the exact leverage ratio banks should be held to — but they can endorse a precautionary principle the reasoning above supports, which is this: We may be uncertain where the right number is, but until equity requirements are manifestly harming the broader economy (and not just banks’ bottom lines), it is safest to keep making them tougher.
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