White Mouse
© Financial Times

To celebrate the second anniversary of the fall of Lehman, the mountain of Basel has laboured mightily and brought forth a mouse. Needless to say, the banking industry will insist the mouse is a tiger about to gobble up the world economy. Such special pleading – of which this pampered industry is a master – should be ignored: withdrawing incentives for reckless behaviour is not a cost to society; it is costly to the beneficiaries. The latter must not be confused with the former. The world needs a smaller and safer banking industry. The defect of the new rules is that they will fail to deliver this.

Am I being too harsh? “Global banking regulators …sealed a deal to …triple the size of the capital reserves that the world’s banks must hold against losses,” says the FT. This sounds tough, but only if one fails to realise that tripling almost nothing does not give one very much.

The new package sets a risk-weighted capital ratio of 4.5 per cent, more than double the current 2 per cent level, plus a new buffer of 2.5 per cent. Banks whose capital falls within the buffer zone will face restrictions on paying dividends and discretionary bonuses. So the rule sets an effective floor of 7 per cent. But the new standards are also to be implemented fully by 2019, by when the world will probably have seen another financial crisis or two.


This amount of equity is far below levels markets would impose if investors did not continue to expect governments to bail out creditors in a crisis, as historical experience shows (see chart). It would not take much of a disaster to bring such leveraged entities close enough to insolvency to panic uninsured creditors. These new ratios are also very much the children of Basel II, the previous regulatory regime: they rely on what should by now be discredited risk-weightings – one of the points Martin Hellwig of Germany’s Max Planck Institute makes in a superb recent paper on the intellectual bankruptcy of current approaches to regulation of capital. We might think of the new requirements as a “capital inadequacy ratio”.

A number of analysts run the possible impact of regulation through standard economic models. The Bank for International Settlements and Financial Stability Board, most notably, have produced a paper which concludes that “a 1 percentage point increase in the target ratio of tangible common equity to risk-weighted assets is estimated to lead to a [median] decline in the level of gross domestic product by a maximum of about 0.19 per cent from the baseline path after four-and-a-half years” (see chart).

Surprise, surprise: representatives of the industry produce estimates that are roughly eight times greater. The official report responds tartly that: “The industry estimates assume that, absent any strengthening of regulation, banks will prefer to increase their leverage in the coming years, returning to levels that prevailed immediately preceding the crisis; that the financial firms’ required return on equity will rise as the government safety net is weakened; and that the link between aggregate credit growth and real GDP is roughly the average from the high-credit growth period preceding the crisis.”

Any such modelling of the costs of regulation is Hamlet without the ghost: it ignores what drives the plot. We cannot assess the costs of regulation without recognising a few facts: first, both the economy and the financial system have just survived a near death experience; second, the costs of the crisis include millions of unemployed and tens of trillions of dollars in lost output, as the Bank of England’s Andy Haldane has argued; third, governments rescued the financial system by socialising its risks; finally, the financial industry is the only one with limitless access to the public purse and is, as a result, by far the most subsidised in the world.

Wolfie charts for Comment
© Financial Times

It is necessary to go back to first principles in assessing the alleged costs of higher capital (and liquidity) requirements.

First, it is untrue that equity is expensive, as another excellent paper by Anat R. Admati of Stanford university and others argues, once we allow for the fact that more equity reduces the risk to creditors and to taxpayers, as we should. Less equity means higher returns, but also higher risk (see chart).

Second, to the extent that creditors bear the costs of failure, more equity means cheaper debt. Thus, if debt were truly unsubsidised, changing the ratio of equity to debt should not affect the costs of funding the balance sheet.

Third, to the extent that taxpayers bear the risk, more equity offsets this implicit subsidy. The public at large has zero interest – in fact, a negative interest – in subsidising risk-taking by banks, in general. For this reason, the subsidy it offers by providing free insurance must be offset by imposing higher capital requirements.

Fourth, the public has an interest in imposing higher equity requirements than any individual bank would, in its own interest, wish to bear. Banks create systemic risk endogenously. That cost must be internalised by the decision makers. More risk-bearing capacity is one way of doing so.

Finally, to the extent that the public wants a specific form of risk-taking subsidised – lending to small and medium-sized enterprise, for example – it should do so directly. To subsidise the banking system as a whole, to persuade it to undertake what is but a small part of its activity, is grotesquely inefficient.

The conclusion, then, is that equity requirements need to be very much higher, perhaps as high as 20 or 30 per cent, without the risk-weighting. It would then be possible to dispense with the various forms of contingent capital that are far more likely to exacerbate panic in a crisis than assuage it. It is only because we have become used to these extraordinarily fragile structures that this demand seems so outrageous.

This is not to deny two huge problems.

One is that any such transition will be like taking drugs from an addict. The simplest way to minimise the costs would be for governments to underwrite the additional capital and then, over time, sell what they take up into the market. Even so, the aggregate balance sheets of the banking system probably need to shrink. Such deleveraging almost certainly means a longer period of large fiscal deficits than almost anybody now imagines.

The other is that there is tremendous potential for regulatory arbitrage, with risks shifted elsewhere in the system. Such risks can easily collapse back on to the banking system. Thus higher capital requirements for banks will only work if regulators are able to identify the emergence of systemic risks elsewhere.

The regulators are trying to make the existing financial system less unsafe, incrementally. That is better than nothing. But it will not create a safe system. The world cannot afford another such crisis for at least a generation. By these standards what is emerging is simply insufficient. This mouse will never roar loudly enough.

martin.wolf@ft.com

Copyright The Financial Times Limited 2024. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section

Follow the topics in this article

Comments