August 12, 2013 5:47 pm

Blame bank regulation for Britain’s stagnation

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The financial sector’s inability to support growth is due to regulatory pressure, says Adam Ridley
England, London, Bank of England illuminated at dusk, side view©Getty

As the dust settled from the great crisis of 2007-09, it was agreed that Britain’s central bank and regulatory machinery could deliver growth and control inflation but it could not adequately spot or regulate financial risk. So we rushed to make banks safe by forcing them to strengthen their capital and liquidity, and we made them deleverage very fast. The coalition government also asked the Bank of England to conduct prudential supervision, to cure the systemic weakness of the old regime.

However, the worst of the crisis has long passed. Since 2009, an equal priority should have been to promote the recovery of the real economy and to support its borrowing needs, particularly given the cutting of the government’s fiscal deficit. This fixation with the banking system is now excessive.

Is the new system supporting recovery? Sadly, no. That much is obvious to any reader of the Financial Times. Inflation is no longer an issue, and gross domestic product has been stagnant for five years. Net bank lending to the non-financial private sector has been contracting and continues to contract, despite the virtues of the “Funding for Lending” and “Help to Buy” schemes. The development of such ad hoc policies can be seen as an admission by ministers that the banks no longer play their full lending role unaided.

But this inability is not intrinsic: it is largely because of the regulatory pressures now being piled on their balance sheets. Prudential regulators everywhere continue to call for banks to cut their lending and assets, and to raise their prudential capital ratios, with little apparent regard for the impact that this will have on growth. Recently, their conduct and decisions have become controversial, perhaps even acrimonious.

In June we learnt that the UK regulators were imposing at short notice new, demanding regulatory ratios on at least two major British lenders – Barclays and Nationwide. There are particularly tough criteria for mortgages, even though these two lenders account for 30 per cent of new UK house lending; and earlier deadlines for raising leverage ratios. In July senior regulators were publicly criticising the banks for “sneaking” to the Treasury about the harsh new regulatory standards for capital and liquidity, which further constrain their ability to lend.

Recently two senior ministers have joined in the fun. Vince Cable, business secretary, warned publicly that the “capital Taliban” among the regulators are demanding draconian standards that will hold back business lending. Meanwhile, George Osborne, the chancellor, had warned of the dangers of regulation that would bring to the country “the stability of the graveyard”.

The common thread in these controversies is how best to handle the banks’ transition from low prudential ratios to the demanding levels that they must, in time, achieve. Getting from here to there is harder than it looks. Take raising new capital. For a bank to raise billions of pounds of new equity at a reasonable price ideally requires several conditions to be met.

First, prospective shareholders must be reasonably confident that the regulatory regime is stable; and that the bank will not continue to be required from time to time, and at very short notice, to increase its capital or liquidity ratios yet again. Banks and investors have not yet regained that confidence. Until they do, the price of new equity will be higher, investors fewer and existing shareholders more unhappy at the risk of dilution.

There needs to be care about the pace of “deleveraging”. Reducing bank assets is not a simple process that can be implemented quickly and at short notice. It comes with a cost and causes trouble, particularly when the cut required is hundreds of billions of pounds or 20 per cent of assets. It may have damaging consequences, both directly for conventional lending and indirectly for important financial transactions that support the real economy.

After years of stagnant output and contracting bank credit to the real economy and housing sector, future moves to new prudential ratio targets need to be calibrated carefully to ensure growth in the real economy can obtain the support it needs. Perhaps the required rise in bank capital buffers can be tied to targets for growth in nominal GDP?

With GDP still below its level of five years ago, we cannot go on as we have in the recent past. Mr Osborne repeatedly underlined the growth objective in a letter to the governor of the Bank of England, sent in April, about the new Financial Policy Committee’s remit: “It is particularly important, at this stage of the cycle, that the committee takes into account and gives weight to the impact of its actions on the near-term recovery.”

Let us hope that Mark Carney, the new BoE governor, and the FPC respond effectively to that challenge. If they do not, they risk presiding over a mirror image of the previous regulatory machinery: a system that can regulate risk, but is unable to deliver economic growth. If they do that, the government will have replaced one defective system with another.

The writer is chairman of the Equitas Trust, a director of Morgan Stanley Bank International, and a former director-general of the London Investment Banking Association

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Letters in response to this article:

Let’s just carry on where we left off! / From Mr Richard Ross

Just in case we were forgetting / From Mr Stephen Rothwell

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