HOW TO STOP THE FIRE SPREADING IN EUROPE´S BANKS / THE FINANCIAL TIMES COMMENT & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

January 4, 2012 7:33 pm

How to stop the fire spreading in Europe’s banks

By Enrico Perotti

The Great Fire of 1666 which devastated London originated with a small flame, which spread rapidly across crammed wooden buildings. The loss was immense. What did city elders do to avoid a repetition? Force households to keep a bucket of water, or mandate city houses henceforth to be built from bricks and stone?


The correct answer is B. It was more expensive, but essential. I am sure many Londoners objected to the higher cost. But buckets, while fine for villages, are not for cities of closely connected buildings. Bricks and stone stop fire spreading.

Now, as the strength of Europe’s banking sector is again a subject of highest concern, the 17th century analogy is all too relevant for policymakers. Four years after the world’s banking system nearly burned down, Europe must still confront the risk of a destructive force as it ratifies – ahead of other jurisdictions – the new “Basel III” rules for financial architecture. Higher capital requirements (stone foundations) and tougher liquidity rules (fire-resistant buildings) must restore resilience, moving banks away from a failed model, which relied on too much credit using unstable sources of liquidity (flammable material).

But we cannot wait for the Basel III builders. Under the new rules, the liquidity coverage ratio, which requires banks to hold stocks of liquid assets, does not take effect until 2015. This is not enough. Recently, liquidity buffers have been quickly run down, without ending the conflagration. The truth is that there is not enough safe sovereign debt in the world. Making the “water buckets” larger by allowing more assets to qualify as “liquid” may not help much. Only central bank “hydrants” stop runs, but they ultimately debase the currency.


The serious new standards on “construction” are delayed even further, until 2008, to continue the Great Fire analogy, we are like Londoners waiting until 1676 before laying the foundation stone. Net stable funding ratios limit the stock of unstable funding (flammable material) by encouraging longer-term borrowing.


It is more expensive, but also more resilient. Overall, the NSFR can induce more gradual credit expansion, lending that is locally focused and fewer global bets.


But banks are resisting this fiercely. Regulators are under pressure to dilute and postpone. There is a real risk that collective resistance during the grace period will make implementation impossible. The further the industry is from meeting the standards, the more bankers can argue that the rules are unattainable. To overcome resistance and ensure timely adjustment, regulators need strong transitional tools.


Central banks should be empowered to apply “prudential risk surcharges” on the gap between a bank’s current liquidity position and the Basel III ratios. These charges compensate for and discourage the creation of systemic risk. Co-ordinated by the new European Systemic Risk Board, surcharges would start low but be raised when circumstances allow to nudge banks into compliance.


The surcharge would make it more expensive for banks to rely on short-term funding, which will reduce yields for investors. However, this will also correct a major loophole. Right now, wholesale short term funding is de facto insured but evades deposit insurance charges. This may have a slight impact on the cost of credit. But stable credit is less costly than cyclical banking for businesses and taxpayers.


The surcharge would induce early adoption of safer standards, while giving banks the flexibility to plot their own path to convergence. Countercyclical charges could be relaxed in hard times but also push for faster adjustment in good times.


Adjusting the charges would be smoother than adjusting or postponing the ratios entirely. Surcharges are also better than higher interest rates, which hit everyone and not just the gamblers.


International co-ordination of surcharge rate setting is desirable. But a level playing field requires that riskier banks face higher charges, or else competition is distorted. Unlike transaction taxes, charges on liquidity risk target the creation of risk itself, contributing to financial and fiscal stability.


Co-ordinated rate-setting also ensures a common convergence process, in place of each country setting its own transition rules. Rate flexibility in the transition would also reinforce the cohesion of the euro area, reducing the rigidity imposed by a single currency.


Waiting for Basel III is not enough. Among still hot ashes, history should guide planners to rebuild the city of finance wisely.

The writer is professor of finance at the University of Amsterdam and 2001-2012 Houblon Norman Fellow at the Bank of England

Copyright The Financial Times Limited 2012.