A crowd flowed over London Bridge: September 2008 was the cruellest month
When I was a bank regulator (among other things) from 1995 to 2003, an in-depth knowledge of the Basel Capital Accord was not an asset at dinner parties. Every now and then someone would be incautious enough to ask what it was I did all day in Canary Wharf. Being a literal-minded fellow, I would begin to wax lyrical about “risk-weighted assets” and “loss given default rates,” but my wife, who had powerful antennae in this area, would quickly rescue my unfortunate interlocutor. “He’s just being polite, dear,” she would remind me, “no one actually wants to know the answer.”
Now everyone is an expert on regulation. Politicians who would struggle to tell an impaired asset from a contingent liability have firm views on the finer points of Basel 3 (bank reform plans created by the Basel Committee on Banking Supervision and one of the main responses to the 2008 financial crisis). But now that the appetite for tougher regulation has been whetted, there is a danger that we end up with a regime that constrains the banks, with damaging consequences for companies and households. Tighter rules may also create stronger incentives for risk-taking activities to move out of the regulated sector, making it even harder to maintain stability.
Regulators can win applause by publicly arguing for rules tougher than the globally-agreed standards. When Michel Barnier, the European Commissioner for the internal market, suggested recently that the new European rules should apply evenly across all member states, the British government demanded the right to put in place even tougher standards. It planned to make banks hold more capital than demanded by Basel 3—an intriguing reversal of decades of British policy, which has consistently sought exemptions from European impositions. When Alan Greenspan, the former chairman of the Federal Reserve, suggested in the Financial Times at the end of July that the new rules might choke off growth, he was subjected to a torrent of abuse.
We all know why things have changed. The 2008 crisis made people uncomfortably aware that banks could seriously damage their wealth. They know that the regulators allowed banks to ratchet up their borrowing in the five or so years leading up to the crash, and that banks’ emergency reserves were inadequate to cover the losses that emerged when the US housing market turned and recession struck.
Vanishingly few politicians cared about these developments when they occurred. On the day I left the Financial Services Authority (FSA) in 2003 I sent Chancellor Gordon Brown a letter, on the model of an ambassadorial valedictory despatch. One point I made was this: “I detect an unhealthy reverence for the wholesale financial markets, across the political spectrum. The City is seen as a goose that lays golden eggs, and therefore one to which it is dangerous to say ‘boo,’ for fear it flies away. Yet the major firms are riven with conflicts of interest, and have demonstrated that it is dangerous to rely on their internal ethical standards… [but] there seems to be little political appetite for the kind of changes that are needed. Ministers, and members of parliament, have so far been almost silent on the subject.” I did not receive a reply.
In the late 1990s, bank supervisors identified flaws in the original Basel Capital Accord, Basel 1, which was devised in the late 1980s to require internationally active banks to hold a reserve—a stock of emergency capital—equivalent in size to at least 8 per cent of their balance sheet. This reserve would be needed if banks lost more than expected on their lending. In principle, supervisors could increase the size of that reserve if a bank’s assets were unusually risky, and the Bank England an later the FSA typically did so. But the variations were normally small—1 per cent or so—and the calculations of risk were primitive, and based on the output of the ratings agencies.
Basel 2 overhauled the rules to make them more risk-sensitive, but though there were undoubtedly improvements, the overall level of capital in the system remained roughly the same. And banks were still allowed to stock their emergency reserves with exotic assets such as hybrid and convertible instruments, highly inventive assets which, when the crisis hit, proved useless.
So in mid-crisis, the G20 asked for a rapid, complete overhaul and the result was Basel 3. It was produced in double-quick time, though full implementation will be another matter. (The Americans never got round to implementing Basel 2, and the Federal Reserve Bank is promoting its own version, known as Basel 2.5.) The new rules will be challenging for some banks, especially in Europe. From now on, emergency reserves must be much bigger and composed of more reliable stuff. The biggest, systemically significant, institutions will have to hold an additional buffer, up to another 2.5 per cent to take account of the risks their failure would pose to the whole system.
This amounts to a hefty increase in bank capital. Yet some countries, including Britain and Switzerland, are considering going further. There is a strong current of academic thinking which maintains that even these higher numbers are well below what is needed to make the banking system truly safe, and to avoid future bailouts. David Miles, an external member of the Bank of England’s Monetary Policy Committee, has proposed a minimum capital level of 20 per cent.
Certainly higher capital makes banks safer. But who would pay the price? The issue is whether making the banks safer will constrain their ability to lend. It may also increase the cost of credit and in turn reduce economic growth.
The Basel Committee addressed this issue directly in its proposals. Its economists argued that the impact would be modest. They accepted that growth would be somewhat lower as a result, but that real GDP—that is, adjusted for inflation—would be appreciably less than 0.5 per cent lower, after five years. The implication was that if banks were forced to hold more capital, the economic costs would be negligible. The banks reacted with incredulity, and began their own study. Others were also sceptical. The OECD has since published a paper which more than doubles the Basel estimate, and estimates that in Europe, GDP would be more than 1 per cent lower after five years—not a huge effect perhaps, but noticeable. The Institute of International Finance, the trade body for the largest global banks, believes that the effect would be much greater, and that GDP in developed countries would be more than 3 per cent lower by 2016.
Should we worry about these differences? Are they just another example of the tendency of economists to exaggerate their disagreements? Perhaps, but the consequences of getting this wrong are serious, so we need to understand the sources of the competing assessments.
Part of the answer lies in what is called the Modigliani and Miller (M&M) theorem. Devised by the economists Merton Miller (pictured, above left) and Franco Modigliani in the late 1950s, the theorem is one of the building blocks of modern finance. Roughly, M&M argues that a company cannot change its cost of capital (the cost of all debt and equity invested in the business) by altering the proportions of debt and equity in its balance sheet. More equity will make a company safer and reduce the cost of its debt.
But there are reasons to doubt whether the pure theory of M&M applies to banks at present. First, dividends, which companies pay to their shareholders, are not tax deductible, while the interest payments that companies make on their debt are. Many people are beginning to believe that this is an anomaly, and should be changed, but I do not expect global agreement on that point in my lifetime. So an increase in equity may well increase the overall cost of bank capital.
Second, it is reasonable to ask whether investors will quickly come to accept that banks are indeed safer, in the light of the last few years. Modigliani himself acknowledged that investors have to be tempted out of traditional investments into different types of asset and may take some time to behave rationally in new circumstances. This is known as the preferred habitat theory. Investors are like wild animals and plants in this respect.
Those who argue for a step change think little of these arguments. In a recent paper, David Miles notes that the additional equity capital which new rules would require that banks have is around $1 trillion. But this, while a large sum, is only around 5 per cent of their total debt financing. So if they replaced some of their debt with equity, Miles believes, this $1 trillion would be quite achievable, and would have positive consequences all round. Still, there is the possibility that debt holders will not be happy to convert to equity in this way. Europe’s population is ageing, and older investors tend to prefer to hold bonds to equities. The other reason is new European insurance regulation, which will require those firms to hold more bonds. The upshot is that banks may have to compete for a smaller pool of equity.
It is hard to know who will get the best of this debate, the banks or the hawkish regulators. But the uncertainty argues for caution, which is no doubt why Basel has proposed a lengthy transition. That is wise, in my view, as a sudden change could cause a hiatus in markets. It might oblige banks to achieve stronger balance sheets by reducing lending, rather than by increasing reserves—and so would make recovery an even more distant prospect. The balance of risks has altered this summer: the possibility of a double dip recession looms before us, and the quality of eurozone debt held by banks has deteriorated.
Tougher requirements on banks will also further stimulate what is known as the shadow banking sector, where the stringent new rules do not apply. The rapid expansion of leverage in hedge funds, private equity funds and the rest was also part of the story of the crisis.
It is time to pay a modest amount of attention to the complaints of the banks about a one-way ratchet towards higher and higher capital. Their credibility is understandably low, and they have to overcome the familiar charge “they would say that, wouldn’t they?” But the greatest risk of over-enthusiastic re-regulation is that it could damage economic growth itself.
When I was a bank regulator (among other things) from 1995 to 2003, an in-depth knowledge of the Basel Capital Accord was not an asset at dinner parties. Every now and then someone would be incautious enough to ask what it was I did all day in Canary Wharf. Being a literal-minded fellow, I would begin to wax lyrical about “risk-weighted assets” and “loss given default rates,” but my wife, who had powerful antennae in this area, would quickly rescue my unfortunate interlocutor. “He’s just being polite, dear,” she would remind me, “no one actually wants to know the answer.”
Now everyone is an expert on regulation. Politicians who would struggle to tell an impaired asset from a contingent liability have firm views on the finer points of Basel 3 (bank reform plans created by the Basel Committee on Banking Supervision and one of the main responses to the 2008 financial crisis). But now that the appetite for tougher regulation has been whetted, there is a danger that we end up with a regime that constrains the banks, with damaging consequences for companies and households. Tighter rules may also create stronger incentives for risk-taking activities to move out of the regulated sector, making it even harder to maintain stability.
Regulators can win applause by publicly arguing for rules tougher than the globally-agreed standards. When Michel Barnier, the European Commissioner for the internal market, suggested recently that the new European rules should apply evenly across all member states, the British government demanded the right to put in place even tougher standards. It planned to make banks hold more capital than demanded by Basel 3—an intriguing reversal of decades of British policy, which has consistently sought exemptions from European impositions. When Alan Greenspan, the former chairman of the Federal Reserve, suggested in the Financial Times at the end of July that the new rules might choke off growth, he was subjected to a torrent of abuse.
We all know why things have changed. The 2008 crisis made people uncomfortably aware that banks could seriously damage their wealth. They know that the regulators allowed banks to ratchet up their borrowing in the five or so years leading up to the crash, and that banks’ emergency reserves were inadequate to cover the losses that emerged when the US housing market turned and recession struck.
Vanishingly few politicians cared about these developments when they occurred. On the day I left the Financial Services Authority (FSA) in 2003 I sent Chancellor Gordon Brown a letter, on the model of an ambassadorial valedictory despatch. One point I made was this: “I detect an unhealthy reverence for the wholesale financial markets, across the political spectrum. The City is seen as a goose that lays golden eggs, and therefore one to which it is dangerous to say ‘boo,’ for fear it flies away. Yet the major firms are riven with conflicts of interest, and have demonstrated that it is dangerous to rely on their internal ethical standards… [but] there seems to be little political appetite for the kind of changes that are needed. Ministers, and members of parliament, have so far been almost silent on the subject.” I did not receive a reply.
In the late 1990s, bank supervisors identified flaws in the original Basel Capital Accord, Basel 1, which was devised in the late 1980s to require internationally active banks to hold a reserve—a stock of emergency capital—equivalent in size to at least 8 per cent of their balance sheet. This reserve would be needed if banks lost more than expected on their lending. In principle, supervisors could increase the size of that reserve if a bank’s assets were unusually risky, and the Bank England an later the FSA typically did so. But the variations were normally small—1 per cent or so—and the calculations of risk were primitive, and based on the output of the ratings agencies.
Basel 2 overhauled the rules to make them more risk-sensitive, but though there were undoubtedly improvements, the overall level of capital in the system remained roughly the same. And banks were still allowed to stock their emergency reserves with exotic assets such as hybrid and convertible instruments, highly inventive assets which, when the crisis hit, proved useless.
So in mid-crisis, the G20 asked for a rapid, complete overhaul and the result was Basel 3. It was produced in double-quick time, though full implementation will be another matter. (The Americans never got round to implementing Basel 2, and the Federal Reserve Bank is promoting its own version, known as Basel 2.5.) The new rules will be challenging for some banks, especially in Europe. From now on, emergency reserves must be much bigger and composed of more reliable stuff. The biggest, systemically significant, institutions will have to hold an additional buffer, up to another 2.5 per cent to take account of the risks their failure would pose to the whole system.
This amounts to a hefty increase in bank capital. Yet some countries, including Britain and Switzerland, are considering going further. There is a strong current of academic thinking which maintains that even these higher numbers are well below what is needed to make the banking system truly safe, and to avoid future bailouts. David Miles, an external member of the Bank of England’s Monetary Policy Committee, has proposed a minimum capital level of 20 per cent.
Certainly higher capital makes banks safer. But who would pay the price? The issue is whether making the banks safer will constrain their ability to lend. It may also increase the cost of credit and in turn reduce economic growth.
The Basel Committee addressed this issue directly in its proposals. Its economists argued that the impact would be modest. They accepted that growth would be somewhat lower as a result, but that real GDP—that is, adjusted for inflation—would be appreciably less than 0.5 per cent lower, after five years. The implication was that if banks were forced to hold more capital, the economic costs would be negligible. The banks reacted with incredulity, and began their own study. Others were also sceptical. The OECD has since published a paper which more than doubles the Basel estimate, and estimates that in Europe, GDP would be more than 1 per cent lower after five years—not a huge effect perhaps, but noticeable. The Institute of International Finance, the trade body for the largest global banks, believes that the effect would be much greater, and that GDP in developed countries would be more than 3 per cent lower by 2016.
Should we worry about these differences? Are they just another example of the tendency of economists to exaggerate their disagreements? Perhaps, but the consequences of getting this wrong are serious, so we need to understand the sources of the competing assessments.
Part of the answer lies in what is called the Modigliani and Miller (M&M) theorem. Devised by the economists Merton Miller (pictured, above left) and Franco Modigliani in the late 1950s, the theorem is one of the building blocks of modern finance. Roughly, M&M argues that a company cannot change its cost of capital (the cost of all debt and equity invested in the business) by altering the proportions of debt and equity in its balance sheet. More equity will make a company safer and reduce the cost of its debt.
But there are reasons to doubt whether the pure theory of M&M applies to banks at present. First, dividends, which companies pay to their shareholders, are not tax deductible, while the interest payments that companies make on their debt are. Many people are beginning to believe that this is an anomaly, and should be changed, but I do not expect global agreement on that point in my lifetime. So an increase in equity may well increase the overall cost of bank capital.
Second, it is reasonable to ask whether investors will quickly come to accept that banks are indeed safer, in the light of the last few years. Modigliani himself acknowledged that investors have to be tempted out of traditional investments into different types of asset and may take some time to behave rationally in new circumstances. This is known as the preferred habitat theory. Investors are like wild animals and plants in this respect.
Those who argue for a step change think little of these arguments. In a recent paper, David Miles notes that the additional equity capital which new rules would require that banks have is around $1 trillion. But this, while a large sum, is only around 5 per cent of their total debt financing. So if they replaced some of their debt with equity, Miles believes, this $1 trillion would be quite achievable, and would have positive consequences all round. Still, there is the possibility that debt holders will not be happy to convert to equity in this way. Europe’s population is ageing, and older investors tend to prefer to hold bonds to equities. The other reason is new European insurance regulation, which will require those firms to hold more bonds. The upshot is that banks may have to compete for a smaller pool of equity.
It is hard to know who will get the best of this debate, the banks or the hawkish regulators. But the uncertainty argues for caution, which is no doubt why Basel has proposed a lengthy transition. That is wise, in my view, as a sudden change could cause a hiatus in markets. It might oblige banks to achieve stronger balance sheets by reducing lending, rather than by increasing reserves—and so would make recovery an even more distant prospect. The balance of risks has altered this summer: the possibility of a double dip recession looms before us, and the quality of eurozone debt held by banks has deteriorated.
Tougher requirements on banks will also further stimulate what is known as the shadow banking sector, where the stringent new rules do not apply. The rapid expansion of leverage in hedge funds, private equity funds and the rest was also part of the story of the crisis.
It is time to pay a modest amount of attention to the complaints of the banks about a one-way ratchet towards higher and higher capital. Their credibility is understandably low, and they have to overcome the familiar charge “they would say that, wouldn’t they?” But the greatest risk of over-enthusiastic re-regulation is that it could damage economic growth itself.
