April 16, 2014 3:57 pm
Regulators’ attempts to hold back the financial tide are futile
We must address excessive bank leverage or face another storm, writes Robert Jenkins
Rain causes flooding and flooding causes damage. Which shall we blame: the rain, the river or an inadequate system of levees? Ocean tides can cause chaos along the coastline. Is the resulting devastation to nearby power plants the fault of nature or of imprudent planning and supervision? What is the proper government response? To regulate the tides and rainfall? No. Would it succeed if it tried? No. Should one focus instead on ensuring essential facilities are solidly built, properly run and protected by levees? Yes.
All obvious and logical. Yet in the area of financial regulation the authorities are flirting with the notion that they can hold back the tides. The US Office of Financial Research has identified the great ocean of capital flows as a source of systemic risk. The Financial Stability Board, which seeks to co-ordinate global regulation, is conducting a consultation with similar questions in mind. And in an otherwise thoughtful speech Andy Haldane, the Bank of England’s rightly respected head of financial stability, said this month that “modulating” investment flows “is the next frontier of macroprudential policy”.
We are working our way through the biggest credit bubble in history. All bubbles feature greed, stupidity and leverage: what sets apart the latest is the magnitude of leverage. We will not abolish greed or stupidity but we can and must address excessive leverage. Have we done so? No. Until we do, another storm will wreak havoc.
Yes, new global standards have been agreed in Basel. They tighten definitions of risk and place an overall cap on leverage. But as currently set, the rules permit bank balance sheets to balloon to 33 times their equity.
At that level bank asset values need fall only 3 per cent to wipe out 100 per cent of capital. A mere 1 per cent drop leaves the institution geared 50 times; a 2 per cent fall, 100 times. How much confidence does that inspire? How long do you think bank creditors will wait around to find out? (Not long in the view of the US authorities. They just announced their intention to reduce leverage a bit further – but, alas, not by much.) Add to the mix the fact that some banks’ balance sheets are equal in size to their home nation’s output and you will grasp central bankers’ admission that we have yet to eliminate the problem of “too big to fail”.
Excessive leverage in the banking system leaves it vulnerable to collapse; authorities know this. Western governments cannot afford a rerun; treasuries know this. The public would not tolerate a repeat performance; politicians know this. So the failure to increase sufficiently the loss-absorbing capacity of the banking system risks triggering a regulatory campaign to spot and control any and all threats that might lead to bank breakdown. And when you start looking for threats you find the world of investment flows is big, complex and could overwhelm the banks’ meagre capital buffers. Then: “Gosh, we better try and control these flows.”
The banking crisis caused epic damage. Policy makers are right to act. But let us not confuse pronouncements with progress.
Capital is both the foundation supporting and the floodwall guarding our credit system. Banks have too little of it. The new banking regulations do not address excess leverage; they enshrine it. So investment flows, like floods and tides, will overwhelm them. By all means then, let us learn more about those flows. And, as with storms and tides, let us try to predict them. But have no illusions about controlling them.
As Canute well demonstrated, even an “all powerful” king could not do so.
Copyright The Financial Times Limited 2014.