The Bank of England’s announcement that UK banks can reduce the “rainy day” capital they had previously been asked to hold — as a countercyclical buffer — is a welcome piece of regulatory dexterity in a Britain that may be entering recession. Yet it is a little like opening an umbrella to deal with an impending hurricane.
While many fear the economic harm from Brexit, the new storm is likely to be caused by the longer-term effect of the latest proposals from the Basel Committee on Banking Supervision, the global bank regulator, and this may prove more damaging to the economies of Europe.
Friday June 24 — the day after the UK voted to leave the EU — was a good day to bury bad news. With ominous timing, Basel had set that deadline three months earlier for responses to its proposals. And, while barely a month goes by when there is not something from Basel awaiting comment, this suggested rule change could be the big one in terms of impact. For the first time since the financial crisis, new proposals will directly affect homeowners, small businesses and larger companies. In short, Basel has lending to the real economy in its sights.
Until now, most post-crisis rule changes have focused on investment banking and related areas. They have either made it harder to run investment banking within a commercial bank (as per the BoE’s ringfencing rules or the Volcker rule in the US) or have made banks put aside more capital for the business. Faced with squeezed profitability, banks have chosen to leave large parts of investment banking — with most shareholders and regulators, and the public, celebrating on the sidelines.
This latest Basel initiative is different. It is again asking banks to hold much more capital than they do today but is focused on traditional lending activities. These are just proposals — the industry’s response has been ferocious and there will be the usual negotiation. There is little doubt, however, that what finally emerges will result in capital requirement for lending activities going up and hence profitability going down.
Unlike previous high-profile retrenchments in the investment banking sector, it would be politically hazardous for a leading bank to announce plans to reduce lending to the real economy. Equally, though, it would be naive to think there will be no strategic response to the Basel recommendations. Banks do not have the luxury of absorbing further hits to their profits.
That does not mean regulators should simply abandon their plans to raise capital requirements for lending to the real economy. The rules covering these loans were crafted in the early 2000s and the financial crisis undoubtedly highlighted deficiencies in their models that need to be addressed.
However, regulators should be realistic about the effect that these rules will have. If the return on equity from mortgage lending or corporate lending falls by more than half — as has been widely estimated under the proposals as drafted — then banks will either ration lending in these areas or try to raise prices. Doing nothing is not an option.
What regulators and policymakers in Europe need to focus on instead, therefore, are the consequences of these proposed rule changes. Their priority should be developing financing solutions other than banks from which customers can borrow.
Specifically, they must deepen Europe’s capital markets rapidly. In the US, banks provide less than one-third of all mortgage and corporate debt; the capital markets provide much of the rest, albeit often indirectly. This means increased capital requirements for US banks in these areas can be absorbed relatively easily. Customers simply borrow from elsewhere.
Europe, however, has no such fallback. Banks provide more than 80 per cent of lending to the real economy and capital market-based alternatives are not a realistic option in a plausible time. Recognising that deepening capital markets takes a while, borrowers may need government help through, for example, reforms to the tax code. Giving companies and individuals greater tax relief on paying interest on servicing bonds than they receive on paying bank loans would be one way to give borrowers an incentive to shun banks and so deepen Europe’s capital markets.
This US electoral season many Republican candidates have reached for the imagery and rhetoric of Ronald Reagan. All those complaining today about banks that appear to be rationing credit, and who are frustrated that banks do not seem prepared to lend to the real economy, should recall a famous saying of America’s 40th president: “You ain’t seen nothing yet.”
The writer is a banking consultant
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