Why banking remains far too undercapitalised for comfort
Leverage ratios closer to 5:1 will help give creditors confidence in liabilities
by Martin Wolf
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Banking sector stability still faces issues 10 years on from the run on Northern Rock © Getty
Just over 10 years ago, the UK experienced, with Northern Rock, its first visible bank run in one-and-a-half centuries. That turned out to be a small event in a huge crisis. The simplest question this anniversary raises is whether we now have a safe financial system. Alas, the answer is no. Banking remains less safe than it could reasonably be. That is a deliberate decision.
Banks create money as a byproduct of their lending activities. The latter are inherently risky.
That is the purpose of lending. But banks’ liabilities are mostly money. The most important purpose of money is to serve as a safe source of purchasing power in an uncertain world.
Unimpeachable liquidity is money’s point. Yet bank money is least reliable when finance becomes most fragile. Banks cannot deliver what the public wants from money when the public most wants them to do so.
This system is designed to fail. To deal with this difficulty, a source of so much instability over the centuries, governments have provided ever-increasing quantities of insurance and offsetting regulation. The insurance encourages banks to take ever-larger risks. Regulators find it very hard to keep up, since bankers outweigh them in motivation, resources and influence.
A number of serious people have proposed radical reforms. Economists from the Chicago School recommended the elimination of fractional reserve banking in the 1930s. Mervyn King, former governor of the Bank of England, has argued that central banks should become “pawnbrokers for all seasons”: thus, banks’ liquid liabilities could not exceed the specified collateral value of their assets. One thought-provoking book, The End of Banking by Jonathan McMillan, recommends the comprehensive disintermediation of finance.
All these proposals try to separate the risk-taking from the public’s holdings of unimpeachably safe liquid assets. Combining these two functions in one class of institutions is a recipe for disaster, because the first function compromises the second, and so demands huge and complex interventions by the state. That is simply not a market solution.
Radical reforms are desirable. But today this is politically impossible. We have to build, instead, on the reforms introduced since the crisis. I was involved in the recommendations from the UK’s Independent Commission on Banking for higher loss-absorbing capacity and the ringfencing of UK retail banks. Both are steps in the right direction. Even so, as Sir John Vickers, chairman of the ICB, noted in a recent speech, the reforms have not yet made the banks’ role as risk-taking intermediaries consistent with their role as providers of safe liabilities. That is largely because they remain highly undercapitalised, relative to the risks they bear.
Senior officials argue that capital requirements have increased 10-fold. Yet this is true only if one relies on the alchemy of risk-weighting. In the UK, actual leverage has merely halved, to around 25 to one. In brief, it has gone from the insane to the merely ridiculous.
The smaller the equity funding of a bank, the less it can afford to lose before it becomes insolvent. A bank near insolvency must not be allowed to operate, since shareholders have nothing left to lose from taking huge bets. There is, however, a simple way of increasing the confidence of a bank’s creditors in the value of its liabilities (without relying on government support). It is to reduce its leverage from 25 to one to, say, five to one, as argued by Anat Admati and Martin Hellwig in The Bankers’ New Clothes.
As Sir John notes, this would impose private costs on bankers, which is why they hate the idea.
But it would not impose significant costs on society at large. Yes, there would be a modest increase in the cost of bank credit, but bank credit has arguably been too cheap. Yes, the growth of bank-created money might slow, but there exist excellent alternative ways of creating money, especially via the balance sheets of central banks. Yes, shareholders would not like it.
But banking is far too dangerous to be left to them alone. And yes, one can invent debt liabilities intended to convert into equity in crises. But these are likely to prove difficult to operate in a crisis and are, in any case, an unnecessary substitute for equity.
The conclusion is simple. Banks are in better shape, on many fronts, than they were a decade ago (though the questionable treatment of income and assets in banks’ accounts continues to render their financial robustness highly uncertain). But their balance sheets are still not built to survive a big storm. That was true in 2007. It is still true now. Do not believe otherwise.
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