I am also a free banking theorist
George Selgin wrote a very true post on Freebanking.org. He claims that we are all, in a way or another, free banking theorists. Why? As Selgin very well explains:
Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims–which is to say any claims about the need for or consequences of government intervention in banking–depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won’t suffice for drawing the sort of sweeping conclusions I’m talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don’t admit (and perhaps don’t realize) it.
Indeed, most banking academic research studies and banking reform proposals base their ideas and models on certain assumptions of how the banking system, left to its own device, would behave, and how to correct the market failures that could possibly arise from such systems.
As my (and most people’s) experience can also testify, this tacit conventional wisdom is present in the mind of the general public and finance practitioners (I can still remember my father’s face when I told him we should get rid of central banks. Like he had just spotted some sort of ghost). The success of the usual US-centric misrepresentation of banking history is almost complete.
With this blog, I have been trying to explain what would (not) have happened if we had left banking free of all the rules that distort its natural behaviour. Seen this way, I am also a free banking theorist. I am trying to get back to the roots, asking questions such as: let’s supposed we never implemented Basel rules, would have real estate lending grown that much over the past three decades? What about securitization? Or interest rates on sovereign debt? And banks’ capital and liquidity buffers? What if we hadn’t had central banks nor deposit insurance over the period? What compounded what?
A lot of this is counterfactual, hence uncertain. Still, the intellectual challenge this represents is worth it, as current banking reformers and regulators still rely on and take for granted the inaccurate conventional story to justify the exponential growth of increasingly tight rules. Rules which, as I explain on this blog, are more likely to harm the banking system than to make it safer.
Larry White once says that free banks should be ‘anti-fragile’, and that the only reason they remain fragile is because of government-institutionalised rules that prevent them from self-correcting and learning. I have also already said that this does not mean that banks would never fail or that no crisis would ever occur. But it is likely that the accumulation of financial imbalances, which under our current system slowly emerge hidden behind the regulatory curtain until it is too late, would appear much sooner, limiting the destructive potential of any crisis. The market process, in order to become anti-fragile, needs to learn through experience. The more ‘safety’ rules one implement the less likely market actors will learn and the more likely the following crisis is going to be catastrophic. Institutionalised paternalism is self-defeating.
Unfortunately, the conventional story has seriously twisted everyone’s mind, and it is highly likely that any government announcing the end of the Fed/ECB/BoE/deposit insurance/currency monopoly would trigger market crashes and a lack of confidence in banks. Most commentators would describe the move as “crazy given what we’ve learnt from history”. In short, it would be a ‘history misreading-induced’ panic. While this would be short-lived, this would also be damaging. It is our role to tell the public that, in fact, it should not fear such changes. It should welcome them.
Myths are slowly being debunked. Slowly…
A few institutions have recently raised voices to try to debunk some of the banking legends that had appeared and became conventional knowledge as a result of the crisis. Here’s an overview.
S&P, the rating agency, just published a note declaring that, surprise surprise, the UK’s ring fencing plans could have clear adverse consequences. Those include: possible downgrade to ‘junk’ status and lower ‘stability’ of the non-ring fenced entities, costs for customers could rise, credit supply could be squeezed, and, what I view as the most important problem of all, ring fencing rules “will undoubtedly further constrain fungibility.” According to the S&P analyst, as reported by Reuters:
“The sharing of resources (and brand, expertise, and economies of scale) means we view most banking groups as being more than the sum of their parts,” the report said.
It said disrupting these benefits could lead S&P to have a weaker view of the group as a whole and to lower its credit ratings on some parts of the banks.
S&P said the complexity of separating functions “represents a significant operational challenge” for banks at a time of multiple other regulations.
I cannot agree more. I have already written four long pieces explaining why intragroup liquidity and capital transfers were key in maintaining a banking group safe. Ring fencing does the exact opposite, putting those liquidity buffers and capital bases in silos from which they cannot be used elsewhere, potentially endangering the whole bank.
The BoE just reported that households could actually cope with raising interest rates. One of the Bank’s justification for not raising rates was that it would push many households towards default, so it is now kind of contradicting itself. And anyway, as I have described previously, lowering rates ceased to translate into lower borrowing rates due to margin compression. Patrick Honohan, Governor of the central bank of Ireland, reported that the exact same phenomenon occurred in Ireland:
Because of the impact on trackers, though, the lower ECB interest rates have not directly improved the banks’ profitability, because the average and marginal cost of bank funds does not fall as much. The banks’ drive to restore their profitability, combined with the lack of sufficient new competition, has meant that, far from lowering their standard variable rates over the past three years as ECB rates have fallen, they have (as is well known) actually increased the standard variable rates somewhat. […] These rates indicate that standard variable rate borrowers are still paying less than they were before the crisis, but not by much. A widening of mortgage interest rate spreads over policy rates also occurred in the UK and in many euro area countries after the crisis, but spreads have begun to narrow in the UK and elsewhere. Until very recently bank competition has been too weak in Ireland to result in any substantial inroads on rates.
This chart exactly looks like what happened in the UK. Spread over BoE/ECB rates have increased, and increasing rates could actually translate into the same level of mortgage rates. This is because, as margin compression starts disappearing, competition can start driving down the spread over BoE/ECB. Households may have to remortgage to benefit from the same rates though.
In Germany, regulators said that the ECB’s negative deposit rates could incite more risk-taking and declared that:
Excess liquidity could even threaten the banking system if it is put to poor use
Regulators vs. ECB. This is getting interesting.
In FT Alphaville, David Keohane reports a few charts from Morgan Stanley. One of them clearly shows the Chinese Central Bank’s use of reserve requirements to manage lending growth. I’m sure my MMT and ‘endogenous money’ friends will appreciate.
The Great Depression and the money multiplier
The money multiplier has collapsed following the introduction of new reserves as central banks engaged in quantitative easing. This has led many economic commentators to declare that the money multiplier did not exist.
While I have several times said that this wasn’t that straightforward, I stumbled upon a post by Mark Sadowski, on Marcus Nunes’ blog, which includes a very interesting graph of the M2 money multiplier (blue line below) from 1925 to 1970 (I have no idea how he obtained this dataset as I can’t seem to be able to go further back than 1959 on the FRED website).
The multiplier collapsed from 7 in 1930 to a low 2.5 in 1940 and banks that had not disappeared had plenty of excess reserves, which they maintained for a number of reasons (precautionary, lack of demand for lending, low interest rates, Hoover/FDR policies…). This situation looks very similar to what happened during our recent crisis. However, what’s interesting is that the multiplier did eventually increase. In 1970, 30 years after reaching the bottom, the multiplier was back at around 6, meaning a large increase in the money stock. This is what most people miss: it doesn’t just take a few years for new reserves to affect lending; it can take decades.
Unless the Fed takes specific actions to remove (or prevent the use of) current excess reserves, the money multiplier could well get back to its historical level within the next few decades.
Liquidity and collateral are two sides of the same coin
I recently wrote a piece listing all the current regulatory constraints that arise from banking regulation and which weigh on liquidity. Unfortunately, there is more. As Singh explained in this FT article (as well as in many of his research papers), monetary policy, and in particular quantitative easing, can have serious repercussions on market liquidity:
From a financial lubrication angle, markets need both good collateral and money for smooth market functioning and, ultimately, financial stability. Having a ready supply of good collateral like US Treasuries or German Bunds also helps in reallocating the not-so-good collateral.
QE that isolates good collateral from the wider market reduces financial lubrication. Its substitute, money that shows up as excess reserves, is basically contained in a closed circuit system built to avoid inflation by introducing “interest on excess reserves”.
Indeed, the combination of QE and Basel rules effectively drives so-called ‘high-quality assets’ out of the market by ‘siloing’ them in various places (central banks’ and banks’ balance sheets, clearinhouses’ margins…). This is what many have dubbed ‘scarcity of good collateral’. (I personally think that Singh is wrong to call all highly rated and liquid assets ‘collateral’. When the Fed buys Treasuries, it doesn’t purchase collateral. It purchases an asset that could potentially be used as collateral. Yet, Singh just uses the word ‘collateral’ in every single circumstance. Semantics I know, but the distinction is important I believe)
The potential solution? Governments could issue more debt, meaning more indebtedness. Not certain this is a good one, especially as increased indebtedness would at some point cause the quality of the asset to decline… (reducing the maturity of existing issues could potentially ease liquidity constraints, but the effect is going to be limited)
JP Koning once declared that he didn’t understand how such ‘collateral shortage’ could even happen. Any asset could serve as collateral, with bigger haircut applied to riskier asset to offset potential market value fluctuations. He is fundamentally right. In a free market, there is no real reason why such shortage should ever appear.
Unfortunately, we do not live in a fully free market, and financial regulations institutionalised the use of certain classes of assets as collateral for certain transactions and increased the required associated haircut (for example, see here for OTC derivatives, see here for shadow banking transactions). Many transactions are also pushed towards central clearing at clearinghouses, which often require posting more (standardised) collateral, hence reducing supply by placing high-quality assets in a silo.
Cash, which can also be used as collateral, is itself siloed at the central bank level because of interest on excess reserves*.
As a result of those new rules, the latest ISDA survey tells us that:
Estimated total collateral in circulation related to non-cleared OTC derivatives has decreased 14%, from $3.7 trillion at the end of 2012 to $3.2 trillion at the end of 2013 as a consequence of mandatory clearing.
Regulations have created a lot of ‘know unknowns’. How the entanglement of all those rules will unravel in a crisis will be ‘interesting’ to follow.
* I know that those reserves don’t usually leave the central bank (unless withdrawn by depositors). But when banks expand their loan book, reserves that were previously in excess suddenly become ‘required’ (unless there is no reserve requirement of course).
The rather curious and awkward alliance between statists and libertarians against free banking
Free banking has a very bad reputation within mainstream economics. As free banking scholars such as George Selgin, Larry White, Kevin Dowd or Steve Horwitz have been demonstrating over the past 30 years, this is mostly due to a misunderstanding of history. The track record of the systems that were as close as possible to free banking is crystal clear however: free banking episodes were more stable than any alternative banking frameworks.
However, this doesn’t seem to please many, from both sides of the political spectrum. Izabella Kaminska, a long-time libertarian critic from FT Alphaville, wrote a piece on the Alphaville blog partly criticizing non-central banking-based banking systems. In two separate replies (here and here), George Selgin highlighted all the self-serving ‘inaccuracies’ of her post (this is a euphemism). He also wrote a rebuttal in a follow-up post. Izabella skipped the interesting bits, accused Selgin of ad hominem, and wrote in turn another unsourced name-calling post on her own private blog. So much for the academic debate.
Perhaps more surprisingly, David Howden just posted a curious article on the Mises Institute website, which described the Fed as arising from “fractional-reserve free banks”. I say surprisingly, because Howden and the Mises Institute are at the other end of the political spectrum: libertarians, and often anarcho-capitalists. Nevertheless, he seemed to agree with Izabella Kaminska to an extent.
Unfortunately, Howden and Kaminska make the same mistake: they misread history, and/or focus far too much on US banking history. First, Howden claims that:
The year 1857 is a somewhat strange one for these clearinghouse certificates to make their first appearance. It was, after all, a full twenty years into America’s experiment with fractional-reserve free banking. This banking system was able to function stably, especially compared to more regulated periods or central banking regimes. However, the dislocation between deposit and lending activities set in motion a credit-fuelled boom that culminated in the Panic of 1857.
This could not be more inaccurate. The so-called ‘US free banking era’ had nothing much to do with free banking. And the credit boom and crises that follow were unrelated to either free banking or fractional reserves (see here for details, as well as below). I’d like Howden to explain why other fractional reserve free banking systems did not experience such recurring crises…
I have been left bewildered by Howden’s claim that privately-created clearinghouses were ‘illegal’ entities involved in ‘illegal’ activities (i.e. issuing clearinghouse certificates to get bank runs under control). Not only does this ironically sound like contradicting laissez-faire principles, but his whole argument rests on a lacking understanding of 19th century US banking.
What Howden got wrong is that, if American banks had such recurring liquidity issues before the creation of the Fed, it wasn’t due to their fractional reserve nature, but to the rule requiring them to back their note issues with government debt, thereby limiting the elasticity of those issues and the ability of banks to respond to fluctuations in the demand for money. Laws preventing cross-state branching also weakened banks as their ability to diversify was inherently limited. Banks viewed local clearinghouses as a way to make the system more resilient. It was a free-market answer to a state-created problem. This does not mean that the system was perfect of course. But Howden the libertarian blames a free-market solution here, and completely ignores the laws that originally created the problem.
Moreover, clearinghouses weren’t only a characteristic of the 19th century US banking system. They were present in several major free banking systems throughout history and set up by private parties (Scotland being a prime example). Their original goal wasn’t to create ‘illegal money claims’, but to help settle large volume of interbank transactions and economise on reserves: they were a necessary part of a well-functioning privately-owned free banking system. US clearinghouse certificates were merely a private solution to tame state-created liquidity crises. Those solutions were not perfect, but Howden is guilty of shooting the messenger here.
Clearinghouse-equivalents still exist today: the German savings and cooperative banks, as well as the Austrian Raiffeisen operate under the same sort of model, in which multiple tiny institutions park their reserves at their local central bank/clearinghouse. Finally, it is necessary to point out that clearinghouse would also surely exist in a full reserve banking system and would have the same basic goal: settle interbank payments.
Why a libertarian such as Howden would be against this natural laissez-faire process is beyond me. My guess is that at the end of the day, it all goes down to the fractional/full reserve banking debate within the libertarian space. Howden is trying at all costs to justify his views that full reserve banking would be more stable. But this time, such rhetoric is counter-productive and only demonstrates Howden’s ignorance of the issue (at least as described in this article). Using the fractional reserve argument to explain the 19th century US crises is self-serving and wholly inappropriate. Blaming a free-market reaction (i.e. the clearinghouse system) to such crises for the creation of the Fed completely misses the point. By doing so, and cherry-picking facts, Howden helps Kaminska’s arguments (despite fundamentally disagreeing with her) and shoots himself in the foot.
Update: I mistakenly thought that Peter Klein had written the article as his profile appeared on it. I should have paid more attention, but David Howden was the author. I have updated the post and apologised to Peter.
Update 2: I only just found out that David Glasner and Scott Sumner also wrote two good posts on free banking and Iza Kaminska/Selgin, followed by very interesting comments (here and here).
Photo: Marvel
All my London photos
After close to 16 months taking pictures of London’s cityscape (of the City of London in particular), I’ve finally decided to open an online album that displays them all! I’ll keep updating it, so please feel free to take a look and share!
https://500px.com/juliennoizet
Liquidity, RIP?
Several months ago, I provided theoretical and historical/empirical evidences that new bank rules put in place in most jurisdictions would harm banking by limiting cross-border and intragroup cross-entity flows of liquidity and capital* (see here, here, here and here). A few weeks ago, I pointed out that some of the most recent banking regulations that formed the pillars of the Basel 3 framework were also limiting market liquidity. Since then, the market liquidity issue has been all over the financial press (see Fitch, which published a warning precisely regarding this point, as well as David Riley, a former colleague of mine (though he probably has no idea who I am!) did the same in the FT here). I promised to get back to the topic so here we are.
Let’s sum up the current constraints on market liquidity:
- Market risk capital requirements: market-making requires banks (broker-dealers) to maintain a certain amount of various securities in inventory to face market demand at a certain price and provide… liquidity. The Basel 3 regime has increased the amount of capital banks have to maintain against various assets and activities. As market-makers, banks are faced with market risk capital requirements (market RWAs), which have been strengthened to help banks absorb losses that could emanate from fluctuations in the market value of their portfolio of securities. As banks try to minimise their capital buffer to maximise their RoE, they tend to now favour smaller inventory sizes, avoiding securities that experience too much market price variations.
- Credit risk capital requirements: but let’s not forget that market-makers are also exposed to default risk on their inventory of fixed income and derivative securities. Here again, Basel 3 has pushed RWAs up on a number of assets. Consequently, the more ‘risky’ bonds a bank holds, the higher its capital requirements. Many banks seem to have decided that the marginal decrease in fixed income inventory (and resulting revenues) would be more than offset by a marginal increase in RoE.
- Liquidity requirements: new rules (Liquidity Coverage Ratio) also require banks to hold a sufficient buffer of very liquid assets to face a 30-day outflow of cash (i.e. redemptions by depositors and other creditors). Of course, regulators have defined what they view as ‘safe and highly liquid’ assets: mostly sovereign and some other highly-rated bonds (and central bank reserves). As a result, many banks have to hold more of those assets than they had originally planned, reducing their available supply, with little flexibility to offload them in case of sudden high market demand. Liquidity rules that require broker-dealers to hold liquid assets against withdrawal of cash margin posted by clients have also been reinforced.
- Funding requirements: banks used to fund their inventories using typically short-term funding instruments such as repurchase agreements. Basel 3 has now introduced tighter standards (Net Stable Funding Ratio) that require some types of bonds to be funded through longer-term (and hence less flexible and possibly more expensive) funding sources (customer deposits or long-term debt). In the words of Daniel Tarullo of the Fed:
On its face, a perfectly matched book might seem to pose little risk to the firm, since it could run off assets as it lost funding. In reality, however, a firm may be reluctant to proceed in so symmetrical a fashion. In such a context, “running off assets” may mean denying needed funding to clients with which the firm has a valuable relationship. Moreover, even if the firm does run off assets, a firm with a large matched book will almost surely be creating liquidity squeezes for these other market actors. To partially address these risks, the NSFR will require firms to hold some stable funding against short-term loans to financial firms.
Unfortunately, all those new constraints reinforce each other. As banks have to hold more safe but low-yielding assets, this puts pressure on their net interest income and thus on their revenues (and this is exacerbated by the low interest rate environment). Those assets also have light (but not non-existent) extra capital requirements, and must be funded by longer-term instruments. By itself, this might lead to a lower level of RoE. Meanwhile, banks have also been subject to new minimum capital ratios, forcing many of them to deleverage. The only rational solution is to cut the balance sheet assets that use too much capital and don’t generate enough revenues, within the new liquidity and funding constraints. This means cutting on inventories (and business lending, but that’s another story).
And, as many have already described, cutting inventories imply reducing liquidity to investors, potentially amplifying a market crash.
Add this lack of market liquidity to a lack of cross-border and intragroup liquidity caused by financial balkanization, and you can potentially achieve a disaster of epic proportions.
Let’s consider this (very) hypothetical story: market tensions arise in a particular jurisdiction/region/country, leading to falling stock/bond market prices. As investors try to exit those markets, local banks experience significant pressure on their inventories and aren’t able to adequately provide the liquidity demanded. Prices fell further as a result, this time endangering banks themselves through their holdings of fair valued and AFS securities. There are bank run threats. Several of those banks are members of larger international banking groups, and their parents/subsidiaries are ready to provide them with extra capital and liquidity, but their regulators prevent them from doing so as they would breach local requirements. As the local banks collapse, news spread that members of international banking groups couldn’t be rescued by their group. International contagion is now likely.
Of course, central banks could provide extra short-term liquidity (though the central bank funding stigma would strike at some point), governments could bailout the banks, etc. But those options would have limited effectiveness: beyond the border, confidence in banking groups would be shattered.
Some regulators acknowledge that new regulations might create some problems. Still, they usually dismiss the issue by saying that, nevertheless, our new system will be more resilient. Ironically, we are now living in a bipolar world: one of excess liquidity injected by central banks and that investors are trying to invest, and another one of reduced liquidity levels as banks cannot deal with investors’ demand. How this mismatch is going to end is anyone’s guess.
* I only very recently found out about this excellent year old CATO Policy Analysis report that reaches the exact same conclusions:
We argue that these measures [i.e. UK’s ring-fencing and US’ Foreign Banking Organization proposals] amount to little more than a mandatory, inefficient shuffling of corporate entities and business units that will not help ward off future financial crises. At the macro level, both proposals interfere with the ability of global banks to allocate capital and liquidity in the manner they determine to be most efficient. We find that the proposals, therefore, threaten to increase financial instability and dampen economic growth and signal an unfortunate step in the wrong direction.
A recent Fed staff study also seems to find that intragroup lending plays the role of buffer against liquidity risk. I let you guess what happens when you limit those intragroup flows.
Vincent points at the new Fatal Conceit
William Vincent, a veteran bank equity analyst, published a very good piece on the SNL website (gated unfortunately).
This is Vincent:
To most people in and around the banking industry, the term Basel III probably means a revised set of capital ratios, building on the two earlier, and failed, Basel structures. They are right, of course. But Basel III means a great deal more. When all of its measures are taken into account, it is clear that regulators are not just introducing another capital ratio regime. They are fundamentally altering how banks are controlled and run.
They are, in short, removing banks’ freedom, within limits, to run themselves as they and their shareholders see fit. In the pursuit of reducing the risk of another global banking crisis, they are tearing up a system that took centuries of trial and error to produce, replacing it with a set of rigid rules that will, in effect, mean that banks’ management will run their institutions on behalf of regulators, not the owners of the business.
To which he adds:
This in itself raises an interesting question: why should regulators be better placed to assess risk than the people who actually do it for a living?
Thumbs up.
Perhaps it is time we raise funds through Kickstarter to send thousands of copies of Hayek’s The Fatal Conceit to regulators?
In defence of the leverage ratio
Regular readers know that I blame risk-based capital requirements for many of the ills of our current banking system. Before the introduction of Basel regulations, banks’ capital level used to be assessed using more standard and simple leverage ratios (equity or capital/total assets). Those ratios have mostly disappeared since the end of the 1980s but Basel 3 is now re-introducing its own version (Tier 1 capital/total exposures).
While I believe there should not be any regulatory minimum capital requirement, I also do believe that, if regulators had to pick one main measure of capitalisation, it should be a standard leverage ratio. All RWA-based ratios should be scrapped.
A new study just added to the growing body of evidence that leverage ratios perform better than RWA-based ones as predictor of banks’ riskiness. Andrew Haldane, from the BoE, has been a long-time supporter of leverage ratios. Admati and Hellwig also backed non-risk weighted ratios. Another paper recently suggested that there was nothing in the literature that justified the level of risk-weights.
Still, most economists, central bankers and regulators consider leverage ratios as mere backstops to complement the more ‘scientific’ (read, more complex, as there is no science behind risk-weights) Basel RWA-based ratios. See this speech from Andreas Dombret, which sums up most criticisms towards simple leverage ratios:
Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns. This would eradicate the corrective influence of capital cover in reducing risk.
Unfortunately, Mr. Dombret and many others are very misinformed.
A leverage ratio would not incentivise banks to leverage up to the allowed limit. Under Basel’s RWA framework, no banks operated with the bare regulatory minimum. Critics forget that different banks have different risk aversion and different risk/reward profiles. Some banks generate relatively low RoEs in return for lower level of risk. Others are willing to take on more risks to generate higher margins and higher RoEs. Banks are not uniform.
Banks would not necessarily pile into the riskiest assets under a leverage ratio either. The answer to this is the same as above. Banks have different cultures and different risk/return profiles to offer to investors. There is no reason why all banks would suddenly lend to the riskiest borrowers to improve their earnings. Such criticism could also easily apply to Basel capital ratios: why didn’t all banks follow the same investment strategy? Critics forget that banks do not try to maximise their profits. They try to maximise their risk-adjusted profits. Finally, such argument only demonstrates its proponents’ ignorance of banking history, as if all banks had always been investing in the riskiest assets in the 300 years before Basel introduced those risk-weights.
RWA-based capital ratios are very patronising: because the riskiness of the assets is already embedded within the ratio, banks are effectively telling markets how risky they are. This became overly sarcastic with Basel 2, which allowed large banks to calculate their own risk-weights (i.e. the so-called ‘internal rating based’ method). It has been proved that, for a given portfolio of assets, risk-weights were considerably varying across banks (see here and here). Given the same balance sheet, one bank could, say, report a 10% Tier 1 ratio, and another one, 14%, implying massive variations in RWA density (RWAs/total assets). A given bank could also change its RWA calculation model (and hence its RWA density) in between two reporting periods, making a mockery of period to period comparison. Of course, all this is approved by regulators. Consequently RWA-based capital ratios became essentially meaningless.
As a result, a leverage ratio would provide a ‘purer’ measure of capitalisation that markets could then compare with their own assessment of banks’ balance sheet riskiness.
Scrapping RWA-based capital ratios would also provide major economic benefits. As regularly argued on this blog, RWA-incentivised regulatory arbitrage has been hugely damaging for the economy and is in large part responsible for the recent internationally-coordinated housing bubbles and ‘secular’ low level of business lending. Getting rid of such regulatory ratio would benefit us all by removing an indicator that has big distortionary effects on the economy.
Of course, there are still a few issues, though they remain relatively minor. The main one is that differences in accounting standards across jurisdictions do not lead to the same leverage ratios (i.e. US GAAP banks have much less restrictions to net their derivative positions than IFRS ones). But those accounting issues can easily be corrected if necessary for international comparison. The second one is what definition of capital to use: common equity? Tier 1 capital? Another problem is the fact that very low risk banks, which don’t need much capital, would also get penalised. In the end, it’s likely that any regulatory ratio will prove distortive in a way or another. Why not scrap them all and let the market do its job?
Chart: Guardian
Chinese regulation, the European way
Some European banking regulators are currently considering the implementation of a sovereign bond exposure cap of 25% of capital to any one sovereign. Their goal is to break the link between sovereigns and banks. I think they don’t really know what they are doing.
European sovereign bond markets are distorted in all possible ways:
- The Basel banking regulation framework has been awarding 0% risk-weight to OECD sovereign debt since the 1980s, meaning purchasing such asset does not require any capital. Recent rules haven’t changed anything to this.
- On the contrary, Basel 3 introduces a liquidity ratio (LCR) basically requiring banks to hold even more sovereign debt on their balance sheet (as part of so-called highly-liquid ‘Level 1 assets’).
- Meanwhile, the ECB, as well as the BoE, have been trying to revive business lending (which suffers from the opposite problem: high risk-weights) by launching cheap funding programmes (LTRO, TLTRO, FLS…). Banks drawn on those facilities to invest in… more 0% weighted sovereign debt, and earn capital-free interest income. We call this the ‘carry trade’.
- Furthermore, investors (including banks) have started seeing peripheral European debt as virtually risk-free thanks to the ECB pledge that it would do whatever it takes to prevent defaults in those countries.
There you are: had European regulators wanted to reinforce the link between sovereigns and banks, they wouldn’t have been more successful. Their usual talk of breaking the link between banks and sovereigns has been completely undermined by their own actions.
The easy solution would have been to scrap risk-weights (or at least increase them on sovereign bonds). But this was too simple, so European policymakers decided to go the Chinese way: never scrap a bad rule; design a new one to fix it; and another one to fix the previous one that fixed the original one.
The new 25% cap would only add further distortion: while Basel’s risk-weights do not differentiate between Portuguese and German bonds, the 25% rule doesn’t either. But, you would retort, this isn’t the point: the point is to limit the exposure to any single sovereign. I agree that diversification is usually a good thing. But 1. lack of diversification has been encouraged by policymakers’ own decisions, and 2. forcing banks to diversify away from the safest sovereigns just for the sake of diversifying may well put many banks’ balance sheet more at risk.
Finally, Fitch estimates at EUR1.1Trn the amount of debt that would need to be offloaded. This is very likely to affect markets and could result in banks taking serious one-off hits on their available-for-sale and marked-to-market bond portfolios, resulting in weaker capital positions. This could also raise overall interest rates, in particular in riskier (and weaker) European countries. Fitch believes banks could rebalance into Level 1-elligible covered bonds. Maybe, but this would only introduce even more distortions in the market by artificially raising the demand for their underlying assets, and this would encumber banks’ balance sheets even further, creating other sorts of risks.
Why pick a simple solution when you can do it the Chinese way?
Photo: picture-alliance / dpa through www.dw.de
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