What with all the recent excitement about Matching Adjustment, Age Co and the PRA’s unfailable insurance stress tests, I clean ran out of time to report on the Adam Smith Institute’s new report on bank capital (report, press release) released last week. This new report includes chapters by John Cochrane, ASI research director Matthew Lesh and yours truly.
During the global financial crisis UK banks experienced losses that more than wiped out their capital. High capital standards are therefore essential to ensure that banks are well placed to withstand a new downturn when that occurs. Now the Bank of England frequently reassures us that banks’ capital levels are much higher than they were, so it comes as a shock to discover that, in market value terms, banks now are even more leveraged than they were on the eve of the crisis. Banks’ leverage has fallen in book value terms, but increased in market value terms, and it is the market values that ultimately matter.
The Bank of England’s capital narrative is as real as the Wizard of Oz.
The implication is that minimum capital requirements need to be much greater than they currently are. In his book, The End of Alchemy, Mervyn King says that a ratio of 10% of equity to total assets would be “a good start”. Note he said total assets, not the fictional ‘risk-weighted assets’ that the bankers game, and that make banks look much stronger than they are. Many other economists would recommend higher capital requirements: 15%, 20% or higher still. The current Basel system has a minimum leverage ratio of only 3% or a little higher if one adds in systemic risk and similar buffers. Such minimum requirements are nowhere near high enough.
The exact minimum number is less important than that it be much higher than it is. A higher minimum means lower leverage, and lower leverage would reduce the risk-taking moral hazard that still infects our banking system. The bankers would no longer be able to keep the profits from their risk-taking but pass the big losses to others.
A higher capital standard could be implemented by stipulating that distributions of dividends and bonus payments, and stock buy backs, would be prohibited until banks met the new capital requirements.
Bankers will object that if they have to hold higher capital, then would have less left over for lending, so lending would fall and the economy would suffer. This argument is fallacious, however. Banks don’t “hold” capital; they issue it. Capital is not an alternative asset to a loan, but an alternative to debt as a means to finance whatever is on the asset side of the bank balance sheet. Empirical evidence also supports the view that higher capital does not mean lower bank lending.
Bankers will also object that they are already subject to onerous prudential and other regulatory burdens. I agree. I would suggest that banks be given a choice: if they meet the new minimum capital requirements, then they should be exempted from the rest of prudential regulation – there should be no obligation to pay levies into the Financial Services Compensation Scheme and so on. Highly capitalised banks would not pose a prudential problem, so there is no good reason why they should be burdened with the costs of complying with prudential regulation.
Of course the banksters bankers will still howl. The real reason is because they won’t like their lunch bucket being taken away. High leverage subsidises their excessive risk-taking.
But it is better for the rest of us that such subsidies should be done away with and higher capital standards would go a long way towards that end.
The object of prudential regulation should be to protect taxpayers from the prospect of being called up on to bail out the banks again when the next crisis comes.
We really don’t want to go through all that again, but it looks like we will.