Solution: Double the capital requirements by earnings retention and paying bonuses in equity, or opt for full structural separation.
Apparently, breaking up the banks is too difficult and too expensive.
That was the disappointing conclusion from the Independent Commission on Banking’s interim report, published last month. Instead of true structural reform we got a mish-mash of compromise remedies, such as higher capital, debt bail-ins, resolution plans, a retail ringfence and branch disposals.
Will these be enough to save taxpayers from a soaking next time the banks crash?
The short answer is no. As the ICB collects responses by 4 July, here are a few thoughts on why – as things stand - taxpayers are still in for a drenching as well as some recommendations for the ICB's final report.
Capital is what keeps banks solvent when loans stop performing and have to be written off. Ideally, there's enough capital to handle losses in a financial crisis, like a sea wall in a storm.
And journalists such as the FT's John Plender think another storm is not far away.
The ICB proposes lifting banks’ core Tier1 equity capital from pre-crisis levels of around 2% to 10% of risk assets. This is a five-fold increase - but do not be fooled.
The trick is in the definition of assets. The ratio applies to risk assets which are smaller than total assets, typically a quarter to half the size. This means the new capital barrier is really only 2.5 to 5% of total assets.
This is less than the rate of non-performing loans at UK banks after the crisis. A year after Lehman Brothers went bust, non-performing loans at European banks jumped to an average of 4.9% of total loans (table 9, IMF). In the UK, they reached 6.1% of total loans in 2010 (p.8, PwC, April 2011). These are averages, so the figures at the worst hit banks could be much worse.
Non performing loans are not the same as actual losses but they are only a step away. What this means is that if the last crisis happened all over again but with UK banks holding the ICB’s minimum capital, the sector's capital could still be washed away. And even if it weren't, any significant erosion could leave banks unable to make new loans for some time, harming the productive the economy.
The point here for the mathematically minded is that while the headline capital ratio (the numerator) has increased, the figure it applies to (the denominator) is still very small.
In the run-up to the crisis, banks found ever smarter ways to shrink this denominator so they could grow returns on equity (a measure that determines banker's pay, among other things) despite low interest rates. Chart 7 from this Bank of England speech gives a neat illustration of the trend, with the coloured dots climbing further uphill every year.
The ratio of risk assets to total assets got smaller and smaller until it shrank the effective capital barrier to a tiny sliver of total assets. Even now, Barclays’ £392bn of risk assets are only a quarter of its £1,492bn total assets, according to its last interim statement. Barclays could satisfy the ICB's requirement with £39bn of core Tier 1 equity, still only 2.6% of its balance sheet.
The headline 10% ratio is therefore an optical illusion, providing only a fraction of the protection needed.
Bank of England guru David Miles, a former chief economist at Morgan Stanley, believes the socially optimal level of bank capital is at least 17-20% of risk assets, nearly double the ICB’s figure. To keep taxpayers dry in a really big storm, they should be as high as 50%, he calculated.
The ICB knows this. It admits that 10% of risk assets is a minimum and says “a case could quite easily be made” for going higher (para 4.34). So why hasn't it?
The cynical answer is that the ICB is trying hard to stop banks from leaving the UK. A slightly less cynical one is that bank equity is expensive. That argument was given the lie both by David Miles, above, and Stamford Universsity's Anat Admati and Martin Hellwig of the Max Planck Institute, in a paper called "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive".
FSA Chairman Lord Turner summarised their findings:
"the costs of higher bank equity requirements are lower and the economic benefits considerably higher than many participants in this debate – from the banking industry but also from public authorities – have in the past assumed."So another explanation of the 10% is needed. The ICB's next argument is that when equity runs out, debt will take over with creditor bail-ins or Cocos.
But “bailing in” bank creditors is not so easy. It barely happened at all in the last crisis, when regulators avoided it for fear of pushing other banks into insolvency.
Inter-bank exposures are famously complex, ranging across treasury and repos to swaps and derivatives, syndicated lending, structured credit, equity finance, trading, collateral and custodial arrangements etc. These areas are not known for their simplicity and transparency.
Unless bank structures are dramatically simplified, regulators and markets will always fear a domino effect.
Second, not all types of debt can be bailed in. Thanks to the Eurozone crisis, several European banks count the ECB among their biggest creditors. There’s little point bailing in central banks as that's just a public bail-out by another name. Bailing in holders of repos and other secured debt is no easier because of legal barriers, and even unsecured creditors can be relied on to challenge a bail-in, especially in cross-border cases. This means bail-ins are slow, difficult and less effective in a crisis than a bail-out with public money.
The ICB looked briefly at whether contingent capital or “CoCos” could automate the process (CoCos are debt that converts to equity at a certain price and trigger). But, it was so worried about CoCos’ vulnerability to speculative attack and the difficulty of finding people to own them that it seems to have given up on the idea.
This is a shame because the Bank of England’s financial stability chief is a big CoCo fan. Andy Haldane calculated that if half the bonuses and dividends paid in the run up to the crisis had been in contingent capital instead of cash, UK banks would have had £70bn in extra loss-absorbing capital in 2008, roughly the amount they had to raise as a result of the crisis.
Even better, if banks were forced to part-pay their high rollers and shareholders in CoCos, they might behave better as, in Haldane’s words, staff would have to “eat their own cooking” if things turned bad.
Sadly, there’s no such recommendation in the ICB’s report.
The ICB's next hope is with bank resolution plans. These are instructions drawn up in advance to help regulators take over a failing bank and settle its affairs at minimal loss to the taxpayer quickly, maybe even over a weekend.
Speed is the key here, since any delay could trigger a market panic.
The problem is that few people think they will work. The idea that executives in a failing investment bank would leave neat little “read me” folders about their disasters seems far-fetched to start with. But even if they were forced to, regulators would still struggle to allocate international multi-billion dollar losses at speed; they would need political agreement on how to share fiscal budget-altering losses between sovereign countries.
The politics of the Eurozone crisis and the USD 1bn plus Lehman’s litigation show how easily the prospect of big losses can put things into slow motion. But even if loss-sharing were agreed in advance there is nothing to stop political leaders from changing their minds in the heat of the moment. It's hard to believe that any amount of preparation could make cross-border bank resolution a reliably fast and certain process.
The G20’s Financial Stability Board and European Commission are exploring loss-sharing protocols but if they don’t completely succeed (and one feels it could be a doomed mission), maybe UK taxpayers should not place too much faith in resolution plans.
ICB must get tougher
The ICB has a few other remedies to explore, some relating to liquidity, others to shadow banking, market infrastructure, ringfencing, competition and possibly remuneration, but the key to keeping taxpayers feet dry is having enough capital to absorb losses.
Unfortunately, the ICB has proposed capital below the level of bad loans in the last banking crisis, and half the level that the Bank of England considers socially optimal. This is like building sea defences below the high tide mark.
Its suggestions for debt bail-ins and resolution plans may act as a layer of sand-bags on top but, as the FSB and ICB have both admitted, these too can be washed away in a storm.
FSA chairman Lord Turner agreed in a recent speech that capital levels should be twice as high as the ICB's proposal, but feared it would be impossible to get there without crashing the economy. He may have been reading this alarmist paper published this month by the IMF's Scott Roger and Jan Vlček in May, which estimated that 2% more bank capital would cost the economy 1% of GDP, rather higher than previous estimates.
These calculations were based on a simplified "closed economy model" and subject to a long list of theoretical assumptions about monetary policy, implementation period, lending spreads, dividends, liquidity requirements etc. The paper's authors admit that it has many limitations, including the failure to consider that banks might hold anything other than risk-free government debt or that they may simply issue new equity, on the grounds that "banks may consider equity issuance, and the dilution of existing shareholder rights, as a last resort measure". Plus, equity issuance didn't fit the academic model.
Previous estimates of the cost to the economy of higher bank capital put the cost far lower. In reality, the cost of building bank capital will fall where politics directs it, and banks have a vested interest in arguing that it should fall on the general public.
Stamford academic Anat Admati, reckons that banks are made of tougher stuff and could easily build capital on their own through retained earnings and mandatory equity issuance. In her view:
"bank equity is not socially expensive, and high leverage is not necessary for banks to perform all their socially valuable functions".The ICB might take her recommendations a stage further and require under-capitalised banks to pay bonuses in new equity until higher capital levels are met, a much neater solution than CoCos.
Wherever you stand on the question of what effect higher capital might have on the real economy, the inescable fact for the ICB is that 10% is still far too low.
ICB head Sir John Vickers was the first to admit that his interim proposals are a compromise. His team is under huge political and lobbying pressure to spare banks from the toughest reforms, especially meaningful structural reform. His final recommendations are not due until September but if he really doesn't want taxpayers to pay for the next banking crisis, his proposals will have to get a lot tougher.