Following my latest post on central banks as the new central planners, a very recent New York Fed Staff Report by Adrian, Covitz and Liang demonstrates the extent of possible central banks’/regulators’ involvement in financial markets, and therefore in what ways they can control, or attempt to control, the allocation of resources within the financial system. Here is a summary of various classes of tools (most of them discretionary) that monetary and financial authorities can play with:
– Monetary policy: the authors classify monetary policy as a “broader tool” that “would affect the rates for all financial institutions”. Indeed, central banks not only set the short-term refinancing rates and reserve requirements and run open market operations, but now also have in place interest rates paid on excess reserves, fixed-rate full allotment reverse repos, as well as various temporary long-term lending facilities such as the BoE’s Funding for Lending Scheme or the ECB’s LTRO and TLTRO, and temporary liquidity facilities such as the ABCP MMF liquidity facility, and can decide what collateral to accept and what securities to purchase, way beyond the traditional Treasury-based OMO.
– Asset markets: central banks can regulate what they view as ‘imbalances’ in the valuation of some asset markets by tightening underwriting standards as well as “through regulated banks and broker-dealers by tightening standards on implicit leverage through securitization or other risk transformations, or by limiting the debt they provide to investors in either unsecured or secured funding markets, if the asset prices are being fuelled by leverage.” In the case of real estate markets and household burdens, central bankers can impose LTV restrictions* and other similar macro-prudential policies.
– Banking policies: central banks have under their control all traditional micro-prudential regulatory tools. In addition, Basel 3 provide them with some flexibility in setting macro-prudential regulatory tools that apply specifically to the banking system, such as counter-cyclical capital requirements (capital conservation buffer, equity systemic surcharge…). Other ad-hoc tools include: sectoral capital requirements (higher/lower capital charges/RWAs for specific asset classes), dynamic provisioning, stress tests…
– Shadow banking policies: harder to regulate, central banks could “address pro-cyclical incentives in secured funding markets, such as repo and sec lending, […] propose minimum standards for haircut practices, to limit the extent to which haircuts would be reduced in benign markets. Other elements of this proposal include consideration of the use of central clearing for sec lending and repo markets, limiting liquidity risks associated with cash collateral reinvestment, addressing risks associated with re-hypothecation of client assets, strengthening collateral valuation and management practices, and improving report, disclosures, and transparency.” Other direct tools include “the explicit regulation of margins and haircuts for macroprudential purposes.”
– Nonfinancial sector: “Tools to address emerging imbalances in asset valuations likely would also address building vulnerabilities in the nonfinancial sector. For example, increasing* [sic] LTVs or DTIs on mortgages, which could reduce a leverage-induced rise in prices, could also limit an increase in exposures of households and businesses to a collapse in prices, thereby bolstering their resilience.”
Given the increased scope of central banks’ operations, it is clear that market prices can be manipulated and distorted in all sort of ways. To be fair however, not all those powers are currently concentrated in the central bankers’ hands. In many countries, there are still a few different institutions that perform those tasks. Nevertheless, the trend is clear: most of those powers are increasingly taken over by and aggregated at central banks.
While this new paper advocates the use of such tools, it admits that their effectiveness and effects on the financial system and the broader economy remains untested and uncertain:
New government backstops to address the risks arising from shadow banking, of course, can be costly. First, an expansion along these lines would require a new regulatory structure to prevent moral hazard, which can be expensive and difficult to implement effectively. Second, an expansion of regulations does not reduce the incentives for regulatory arbitrage, but just pushes it beyond the beyond the existing perimeter. Third, there is a limited understanding of the impact that such a fundamental change would have on the efficiency and dynamism of the financial system.
In a subsequent guest post, Justin Merrill will investigate macro-prudential policy tools more in depth.
* The paper mistakenly describes those potential measures as “increasing” LTV ratios to mitigate house price and household indebtedness increases. I believe this is a typo, even though the same claim reappears several times throughout the paper (if not a typo then the authors have no clue how LTVs work…).
The recent news of the near-bankruptcy of UK-based Cooperative Bank and Portugal-based Banco Espirito Santo made me question the utility of regulatory capital requirements. What are they for? Is raising them actually that useful? It looks to me that the current conventional view of minimum capital requirements is flawed.
In the pre-crisis era, banks were required to comply with a minimum Tier 1 capital ratio of 4% (i.e. Tier 1 capital/risk-weighted assets >= 4%). Most banks boasted ratios of 2 to 5 percentage points above that level. Basel 3 decided to increase the Tier 1 minimum to 6%, and banks are currently harshly judged if they do not maintain at least a 4% buffer above that level.
Indeed, given the possible sanctions arising from breaching those capital requirements, bankers usually thrive to maintain a healthy enough buffer above the required minimum. Sanctions for breaching those requirements include in most countries: revoking the banking licence, forcing the bank into a state of bankruptcy and/or forcing a restructuring/break-up/deleveraging of the balance sheet. Hence the question: what is the actual effective capital ratio of the banking system?
Companies – as well as banks in the past – are usually deemed insolvent (or bankrupt) once their equity reaches negative territory. At that point, selling all the assets of the company/bank would not generate enough money to pay off all creditors (while shareholders are wiped out).
Let’s assume a world with no Tier 1 capital but only straightforward equity, and without regulatory capital requirements. Following the basic rule outlined above, a bank with a 10% capital ratio can experience a 10% reduction in the value of its assets before it reaches insolvency. Let’s now introduce a minimum capital requirement of 6%. The same bank can now only experience a 4% reduction in the value of its assets before breaching the minimum and be considered good for resolving/restructuring/breaking-up by regulators.
For sure, higher minimum requirements have one advantage: depositors are less likely to experience losses. The larger the equity buffer, the stronger the protection.
However, there are also several significant disadvantages.
Given regulators’ current interpretation of the rules, higher minimum requirements also imply a higher sanction trigger. This creates a few problems:
- Raising the minimum threshold does little to protect taxpayers if regulators believe that a bank should be recapitalised, not when its Tier 1 gets close to or below 0%, but when it simply breaches the 6% level. In such case, it might have been possible for the bank’s capital buffer to absorb further losses without erasing its whole capital base and calling for help. For instance, Espirito Santo’s regulators said that its recapitalisation was compulsory: it reported a 5% equity Tier 1 ratio, below the 7% domestic minimum. And the state (i.e. taxpayers) obliged. But… It still had a 5% equity buffer to absorb further losses. Perhaps this would have been sufficient to absorb all losses and spare the taxpayers (perhaps not, but we may never find out).
- When approaching the minimum requirement, bankers are incentivised to start deleveraging in order to avoid breaching. Alternatively, they can be forced by regulators to do so. This has negative consequences on the availability of credit and on the money supply, possibly worsening a crisis through a debt deflation-type bust in order to comply with an artificially-defined 6% level.
- While depositors’ protection can be improved, it isn’t necessarily the case of other creditors, especially in light of the new bail-in rules that make them share the pain (so-called ‘burden-sharing’). Those rules kick in, not when the bank reaches a 0% capital ratio, but when it breaches the regulatory minimum (see here).
- Reaching the minimum requirement can also be self-defeating and self-fulfilling: fearing a bankruptcy event and the loss of their investments, shareholders run to the exit, pushing the share price down to zero and… effectively bringing about the insolvency of the bank. This doesn’t make much sense when a bank still has a 6% capital buffer. Espirito Santo suffered this fate until trading was suspended (see below).
So what’s the ‘effective’ Tier 1 capital ratio? Well, it is the spread between the reported Tier 1 and the minimum regulatory level. A bank that has an 8% Tier 1 under a 4% requirement, and a bank that has a 10% Tier 1 under a 6% requirement have virtually* the same effective capital ratio: 4%.
Regulatory insolvency events also cause operational problems. Espirito Santo was declared insolvent by its regulators but… not by the ISDA association! Setting regulatory minimums at 5% or 25% would have no impact on the issues listed above, as long as this logic is applied. To make regulatory requirements more effective, sanctions in case of breach should be minimal or non-existent in the short-term but should kick in in the long-term if banks’ capitalisation remains too low after a given period of time.
Regulatory minimums exemplify what Bagehot already tried to warn against already at his time: they are bound to create unnecessary panics. Speaking of liquidity reserves (the same reasoning as above applies), he said in Lombard Street:
[Minimums are bad] when legally and compulsorily imposed. In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin, and would run like magic. And the fear would be worse because it would not be unfounded—at least, not wholly. If you say that the Bank shall always hold one-third of its liabilities as a reserve, you say in fact that this one-third shall always be useless, for out of it the Bank cannot make advances, cannot give extra help, cannot do what we have seen the holders of the ultimate reserve ought to do and must do.
* ‘virtually’ as, as described above, depositors protection is nonetheless enhanced, though even this is arguable given what happened in Cyprus
I often refer to the distortive effects of RWA on the housing and business/SME lending channels. What I don’t say that often is that Basel’s regulations have also other distortive effects, perhaps slightly less obvious at first sight.
Basel is highly likely to be partially responsible for sovereign states’ over-indebtedness, by artificially maintaining interest rates paid by governments below their ‘natural’ level.
How? Through one particular mechanism historically, that you probably start knowing quite well: risk-weighted assets (RWA). Basel 1 indeed applied a 0% risk-weight on OECD countries’ sovereign debt*, meaning banks could load up their balance sheet with such instruments without negatively impacting their regulatory capital ratios at all. Interest income earned on sovereign debt was thus almost ‘free’: banks were incentivised to accumulate them to maximise capital-efficiency and RoE.
This extra demand is likely to have had the effect of pushing interest rates down for a number of countries, whose governments found it therefore much easier to fund their electoral promises. In the end, the financial and economic crisis was triggered by the over-issuance of very specific types of debt: housing/mortgage, sovereign and some structured products. All those asset classes had one thing in common: a preferential capital treatment under Basel’s banking regulations.
Basel 2 introduced some granularity but fundamentally didn’t change anything. Basel 3 doesn’t really help either, although local and Basel regulators have recently announced possible alterations to this latest set of rules in order to force banks to apply risk-weights to sovereign bonds (one option is to introduce a floor). Some banks have already implemented such changes (which cost billions in extra capital requirements).
While those measures go in the right direction, Basel 3 has also introduced a regulatory tool that goes precisely the opposite way: the liquidity coverage ratio (LCR). The LCR requires banks to maintain a large enough liquidity buffer (made of highly-liquid and high quality assets) to cover a 30-day cash outflow. As you may have already guessed, eligible assets include mostly… government securities**.
Here again, Basel artificially elevates the demand for sovereign debt in order to comply with regulatory requirements, pushing yields down in the process. This has two consequences: 1. governments could find a lot easier to raise cash than in free market conditions (with all the perverse incentives this has on a democratic process unconstrained by economic reality) and 2. as sovereign yields are used as risk-free rate benchmarks in the valuation of all other asset classes, the fall in yield due to the artificially-increased demand could well play the role of a mini-QE, boosting asset prices across the board ceteris paribus.
We end up with a policy mix that contaminates both central banks’ monetary policies and domestic political debates. But, worst of all, it is a real malinvestment engine, which trades short-term financial solidity for long-term instability.
* Some non-OECD regions of the world also allow their domestic banks to use 0% risk-weight on domestic sovereign debt. For instance, many African countries are allowed to apply 0% weighing on the sovereign debt of their local governments despite the obvious credit risk it represents as well as its poor marketability (this is partly mitigated as this debt is often repoable at the regional central bank). Moreover, the same regulators prevent their domestic banks from investing their liquidity in Treasuries or European debt, with the obvious goal of benefiting those African states. Consequently, illiquid and risky sovereign bonds comprise most of those banks’ “liquidity” buffers, evidently not making those banking systems much safer…
** The LCR is partly responsible for the ‘shortage of safe assets’ story.
Back from holidays, and a lot of things to cover…
Let’s start with Vince Cable, Britain’s Secretary of State for Business, who is making a U-turn, though not yet quite finished, as he progressively realises how much he ignored about the pernicious effects of banking regulation.
The way the regulatory system operates has undoubtedly had a suffocating effect on business lending and particularly on our exporters.
Not surprisingly, the result is that banks pump out lending in the mortgage market, while lending to small businesses is restricted. This directly stems from the rules on which the regulatory model is based and has had a very damaging impact.
You may well recognise that he is referring to risk-weighted assets (RWAs), which have been a recurrent theme of this blog (and the focus of my three latest posts). Vince Cable had already sparked controversy pretty much exactly a year ago, when he first attacked the BoE for being a ‘capital Taliban’:
One of the anxieties in the business community is that the so called ‘capital Taliban’ in the Bank of England are imposing restrictions which at this delicate stage of recovery actually make it more difficult for companies to operate and expand.
This is a welcome reaction by one of the country’s top politician. However, let’s go back a few years to find the same Mr Cable vehemently supporting the exact same reforms he now criticises, while fully rejecting bankers’ claims that increased capital requirements would allocate funding away from SMEs (see here, here, here, here and here):
Banks and industry groups have argued more regulation could force institutions to curb lending to small- and medium-sized businesses at a time when the economy is slowing.
Prediction which turned out to be correct.
Mr Cable’s went from blaming banks for the crisis and justifying stronger regulatory requirements to blaming those same requirements for the weak level of business lending in the UK. Unfortunately, his U-turn isn’t fully completed and Mr Cable attacks the wrong target. Capital requirements are defined in Basel, the Swiss city. And he supported them in the first place, without evidently knowing what those rules involved. He also seemingly showed a poor understanding of banking history as his support for banking insulation through ring-fencing demonstrated (though most regulators are to blame as well).
Better late than never? Perhaps, but probably too late to have any effect going forward… Politicians’ and regulators’ rush to design banking rules in order to please the public opinion is making everyone worse off in the end.
Photo: Rex Features
The IMF got the timing right. It published last week a new ‘Global Housing Watch‘, and warned that house prices were way above trend in a lot of different countries all around the world. The FT also reports here:
The world must act to contain the risk of another devastating housing crash, the International Monetary Fund warned on Wednesday, as it published new data showing house prices are well above their historical average in many countries.
As I said, perfect timing, as this announcement follows my previous post on the influence of Basel’s RWAs on mortgage lending.
As long as international banking authorities don’t get rid of this mechanism, we are likely to experience reoccuring housing bubbles with their devastating economic effects (hint for Piketty: and investors/speculators will have an easy life making capital gains).
PS: I am on holidays until the end of the week, so probably not many updates over the next few days.
Just a very very quick post tonight.
Our business is constrained by the capital we have available to cover risk-weighted assets (RWA) resulting from the risks in our business, by the size of our on- and off-balance sheet assets through their contribution to leverage ratio requirements and regulatory liquidity ratios, and by our risk appetite. Together, these constraints create a close link between our strategy, the risks that our businesses take and the balance sheet and capital resources that we have available to absorb those risks. As described in “Equity attribution framework” in the “Capital management” section of this report, our equity attribution framework reflects our objectives of maintaining a strong capital base and guiding businesses towards activities that appropriately balance profit potential, risk, balance sheet and capital usage.
Where does this come from? The 2013 annual report of UBS, the largest Swiss bank (page 150).
How banks are incentivised by Basel’s risk-weighted assets is clear. What provides has a low capital treatment (= low RWA), has relatively low default risk, is highly collateralised, even though it doesn’t bring in much interest income? Yep, mortgages (as well as some tranches of securitised products such as RMBSs, and sovereign debt).
The Bank of England reported yesterday the latest statistics of one of its flagship measures, the Funding for Lending Scheme. Unsurprisingly, they are disappointing. No, more than that actually: the FLS has been pretty much useless.
When launched mid-2012, the FLS was supposed to offer cheap funding to British banks in exchange for increased business and mortgage lending (though originally, authorities strongly emphasised SMEs in their PR as you can imagine) in order to ‘stimulate the economy’. The only effect of the scheme was to boost… mortgage lending.
The BoE, unhappy, decided to refocus the scheme on businesses (including SMEs) only, in November last year. Well, as I predicted, it was evidently a great success: in Q114, net lending to businesses was –GBP2.7bn and net lending to SMEs was –GBP700m. Since the inception of the scheme, business lending has pretty much constantly fallen (see chart below).
According to the FT:
Figures from the British Bankers’ Association showed net lending to companies fell by £2.3bn in April to £275bn, the biggest monthly decline since last July.
The BoE argues that we don’t know what would have happened without the scheme. Perhaps lending would have fallen even more? That’s a poor argument for a scheme that was supposed to boost lending, not merely reduce its fall. Not even all large UK banks participated in the scheme (HSBC and Santander didn’t). Moreover, some banks withdrew only modest amounts because they could already access cheaper financial markets by issuing covered bonds and other secured funding instruments, or, if they couldn’t, used the FLS to pay off existing wholesale funding rather than increase lending… The FLS funding that did end up being used to lend was effective in boosting… the mortgage lending supply.
The UK government has also ‘urged’ banks to extend more credit to SMEs. Still, nothing is happening and nobody seems to understand why. For sure, low demand for credit plays a role as businesses rebuild their balance sheet following the pre-crisis binge. Still, nobody seems to understand the role played by current regulatory measures. Central bankers are supposed to understand the banking system. The fact that they seem so oblivious to such concepts is worrying.
On the one hand, you have politicians, regulators and central bankers trying to push bankers to lend to SMEs, which often represent relatively high credit risk. On the other hand, the same politicians, regulators and central bankers are asking the banks to… derisk their business model and increase their capitalisation. You can’t be more contradictory.
The problem is: regulation reflects the derisking point of view. Basel rules require banks to increase their capital buffer relatively to the riskiness of their loan book; riskiness measures (= risk-weighted assets) which are also derived from criteria defined by Basel (and ‘validated’ by local regulators when banks are on an IRB basis, i.e. use their own internal models).
Those criteria require banks to hold much more capital against SME exposures than against mortgage ones. Banks that focus on SMEs end up squeezed: risk-adjusted SME lending return is not enough to generate the RoE that covers the cost of capital on a thicker equity base. Banks’ best option is to reduce interest income but reduce proportionally more their capital base to generate higher RoEs. Apart from lending to sovereigns and sovereign-linked entities, the main way they can currently do that is to lend… secured on retail properties…
(I have already described here how this process creates misallocation of capital and possibly business cycles)
As such, it is unsurprising that mortgage lending never turned negative in the UK (even a single month) throughout the crisis. Even credit card exposures haven’t been cut by banks, as their risk-adjusted returns were more beneficial for their RoE than SMEs’. Furthermore, alternative lenders, who are not subject to those capital requirements, actually see demand for credit by SMEs increase (see also here).
Let’s get back to the 29th of November 2013. At that time, after it was announced that the FLS would be modified, I declared:
RWAs are still in place! Mortgage and household lending will still attract most of lending volume as it is more profitable from a capital point of view.
As long as those Basel rules, which have been at the root of most real estate cycles around the world since the 1980s, aren’t changed, SMEs are in for a hard time. And economic growth too in turn. Secular stagnation they said?
PS: this topic could easily be linked to my previous one on intragroup funding and regulators “killing banking for nothing”. Speaking of the ‘death of banking’, Izabella Kaminska managed to launch a new series on this very subject without ever saying a word about regulation, which is the single largest driver behind financial innovations and reshaped business models. I sincerely applaud the feat.
PPS: The FT reported how far regulators (here the FCA) are willing to go to reshape banking according to their ideal: equity research in the UK is in for a pretty hard time. This is silly. Let investors decide which researchers they wish to remunerate. Oversight of the financial sector is transforming into paternalism, if not outright regulatory threats and uncertainty.
PPS: I wish to thank Lars Christensen who mentioned my blog yesterday and had some very nice comments about it.
I recently explained the importance of intragroup liquidity and capital flows to prevent or help solve financial crises and why new regulations are weakening banks, and showed the inherent weakness in the design of the 19th century US banking system. Today I wish to highlight the similarities, and more importantly, the differences, between the 19th century US banking system and the modern German banking system.
As previously described, the peculiar US banking system had a multitude of tiny unit banks that were not allowed to branch, with very little financial flows and support behind them (at least until they started setting up local clearinghouses). By 1880, there were about 3,500 banks in the US, meaning about 1 bank for 14,000 people. Nowadays, there are about 1,800 banks in Germany, meaning one bank for 45,000 people. Germany’s banking system isn’t as fragmented as the 19th century US one, but it is still very fragmented by developed economies’ standards.
By comparison, in the UK, there is one bank for 410,000 people, though most banks have no retail banking market share, meaning this figure is probably way overestimated (my guess is that there is actually one bank for about 3m people). In Germany though, most banks have a retail banking market share: the banking system is divided between the large private banks (which actually don’t account for much of the local retail market share and focus mostly on corporate lending and investment banking), the cooperative banks group (the Volksbanken and Raiffeisenbanken, representing around 1,200 small retail banks), and the savings banks group, the largest banking group in Germany (the Sparkassen-Finanzgruppe, representing slightly less than 450 retail banks).
Those Sparkassen, for instance, cannot compete with each other and cannot branch out of their local area, making both their loan books and funding structures highly undiversified, with restrictions very similar to those that applied to 19th century US banks. Moreover, many of those banks have relatively small capital and liquidity buffers, at least compared to the US banks. Nevertheless, the Sparkassen have demonstrated remarkable resilience over time, experiencing very few failures (all have been bailed out). How to explain this?
First, all Sparkassen depend on local Landesbanks, which, quite similarly to clearinghouses in 19th century US, play the role of local central banks, moving liquidity around according to the needs of their Sparkassen members. This process alleviates acute liquidity crises. But this isn’t enough to avert regional crises or national, systemic ones.
Second, the Sparkassen rely on another mechanism: several regional and interregional support funds that allow healthy banks to recapitalise or provide liquidity to endangered sister Sparkassen. Those support funds can be complemented by extra contributions from healthy Sparkassen if ever needed. This mechanism is akin to some sort of intragroup funds flows*.
Here we go: instead of insulating each bank, raising barriers to allegedly make them more resilient, the Sparkassen allow funds to circulate when needed. They understand that the actual failure of one of their members would have catastrophic ramifications for the rest of the group (and for their shared credit rating). It is in their best interest to mutually support each other. But guess what? Some Sparkassen now fear that European regulators will take action to make such intragroup mutual support flows illegal…
* The Volksbanken have a relatively similar structure and intragroup support mechanism, though there are differences. Both groups are also actively involved in intragroup peer monitoring, which is important to limit moral hazard.
Sam Bowman had a very good piece on the Adam Smith Institute blog about Scotland setting up a pound Sterling-based free banking system unilaterally (yeah I know I keep mentioning this blog now, but activity there seems to have been picking up recently). It draws on George Selgin’s post and is a very good read. One particular point was more than very interesting in the context of my own blog (emphasis added):
George Selgin has pointed to research by the Federal Reserve Bank of Atlanta about the Latin American countries that unilaterally use the dollar. Because these countries – Panama, Ecuador and El Salvador – lack a Lender of Last Resort, their banking systems have had to be far more prudent and cautious than most of their neighbours.
Panama, which has used the US Dollar for one hundred years, is the most useful example because it is a relatively rich and stable country. A recent IMF report said that:
“By not having a central bank, Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages. The authorities emphasized that these features had contributed to the strength and resilience of the system, which relies on banks holding high levels of liquidity beyond the prudential requirement of 30 percent of short-term deposits.”
Panama also lacks any bank reserve requirement rules or deposit insurance. Despite or, more likely, because of these factors, the World Economic Forum’s Global Competitiveness Report ranks Panama seventh in the world for the soundness of its banks.
I don’t think I have anything to add…
SNL reported yesterday that Germany’s laws seem to make the issuance of contingent convertible bonds (CoCos) almost pointless. This is a vivid reminder of my previous post, which highlighted some of the ‘good’ principles of financial regulation and which advocated stable, simple and clear rules, a position I have had since I’ve opened this blog. All authorities and regulators try to push banks (including German banks) to boost their capital level, which are deemed too low by international standards. CoCos, which are bonds that convert into equity if the bank’s regulatory capital ratio gets below a certain threshold, are a useful tool for banks (as it allows them to prevent shareholder dilution by issuing equity) and investors (whose demand is strong as those bonds pay higher coupon rates). Yet lawmakers, who love to bash banks for their low level of capitalisation, seem to be in no hurry to provide a clear framework that would allow to partially solve the very problems they point at in the first place… This is a very obvious example of regime uncertainty. As one lawyer declared:
One thing is clear: Nothing is clear
Bloomberg reports that FX traders are facing ‘extinction’ due to the switch to electronic trading. In fact, this has been ongoing for now several years, with asset classes moving one after another towards electronic platforms. Electronic trading now represents 66% of all FX transactions (vs. 20% in 2001). Traditional traders are going to become increasingly scarce and replaced by IT specialists that set and programme those machines. Overall, this should also mean less staff and a lower cost base for banks that are still plagued by too high cost/income ratios. Part of this shift is due to regulation, which makes it even more expensive to trade some of those products. This only reinforces my belief that regulation is historically one of the primary drivers of financial innovation, from money market funds to P2P lending…
Andreas Dombret, member of the executive board of the Bundesbank, made two very similar speeches last week (The State as a Banker? and Striving to achieve stability – regulations and markets in the light of the crisis). When I started to read them, I was delighted. Take a look:
If one were to ask the question whether or not the market economy merits our trust, another question has to be added immediately: “Does the state merit our trust?”
Sometimes it seems as if we are witnessing a transformation of values and a redefinition of fundamental concepts. The close connection between risk-taking and liability, which is an important element of a market economy, has weakened.
Conservative and risk-averse business models have become somewhat old-fashioned. If the state is bearing a significant part of the losses in the case of a default of a bank, banks are encouraged to take on more risks.
[High bonuses and short-termism] are the result of violated market principles and blurred lines between the state and the banks. They are not the result of a well-designed market economy but rather indicative of deformed economies. However, the market economy stands accused of these faults.
Brilliant. I was just about to become a Dombret fan when…I read the rest:
In my view, the solution is to be found in returning the state to its role of providing a framework in which the private sector can operate. This means a return to the role the founding fathers of the social market economy had in mind.
They knew that good banking regulation is a key element of a well-designed framework for a well-functioning banking industry and a proper market economy in general.
This is where good bank capitalisation comes into play. It is the other side of the coin. Good regulation should directly address the key problem. If the system is too fragile, an important and direct measure to reduce fragility is to have enough capital.
Good capitalisation will have the positive side effect of reducing many of the wrong incentives and distortions created by taxpayers’ implicit guarantees and therefore making the bail-in threat more credible ex ante.
And from the second article:
In view of all this, I believe that two elements will be especially important in making banks more stable: capital and liquidity. Deficits in both of these things were factors which contributed significantly to the financial crisis. The state can bring in regulation to address these deficits, and has done so very successfully.
And on shadow banking:
In terms of financial stability, the crux of the matter is that these entities can cause similar risks to banks but are not subject to bank regulation.And the shadow banking system can certainly generate systemic risks which pose a threat to the entire financial system.
Much the same applies to insurance companies. Although they aren’t a direct component of the shadow banking system, they can also be a source of systemic risk. All of this makes it appropriate to extend the reach of regulation.
Sorry but I will postpone joining the fan club…
Mr. Dombret correctly identifies the issue with the financial system: too much state involvement. What is his solution? More state involvement. It is hard to believe that one person could come up with the exact same solution that had not worked in the past. Were the banks not already subject to capital requirements before the crisis? Even if not ‘high’ enough they were still higher than no capital requirement at all. So in theory they should have at least mitigated the crisis. But the crisis was the worst one since 1929, and much worse than previous ones during which there were no capital requirements. Efficient regulation indeed…
Like 95% of regulators, he makes such mistakes because of his (voluntary?) ignorance of banking history. A quick look at a few books or papers such as this one, comparing US and Canadian banking systems historically, would have shown him that Canadian banks were more leveraged than US banks on average since the early 19th century, yet experienced a lot fewer bank failures. There is clearly so much more at play than capital buffers in banking crises…
Moreover, he views formerly ‘low’ capital requirements as a justification for bankers to take on more risks to generate high return on equity. This doesn’t make sense. For one thing, the higher the capital requirements the higher the risks that need to be taken on to generate the same RoE. It also encourages gaming the rules. This is what is currently happening, as banks are magically managing to reduce their risk-weighted assets so that their regulatory-defined capital ratios look healthier without having to increase their capital.
Mr. Dombret starts by seriously questioning the state’s ability to manage the system and highlights the very harmful and distortive effects of state regulation to eventually… back further and deeper state regulation.
A question Mr. Dombret: what are we going to do following the next crisis? Continue down the same road?
Can please someone remind Mr. Dombret of what a free market economy, which he seems to cherish, means?
Picture: Marius Becker