Why banking remains far too undercapitalised for comfort

Leverage ratios closer to 5:1 will help give creditors confidence in liabilities

by Martin Wolf

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.

Russia’s Foreign Policy of Disruption

By Jacob L. Shapiro


The Trump administration came to office hoping it would be able to find a more cooperative basis upon which to work with Russia than previous U.S. administrations had. Of course, the Bush administration and the Obama administration tried to reset U.S.-Russia relations as well, to no avail. Less than a year into Donald Trump’s presidency, it is already evident that not only has the U.S. failed to change the tenor of relations with Russia, but the relationship has worsened. As recently as March, a spokesman for Russian President Vladimir Putin suggested that the two sides were involved in a new Cold War, and after new sanctions were levied against Russia in June, Moscow promised retaliation. That retaliation is beginning to take shape.

The U.S. is the lone global superpower. On the one hand, that is a reflection of the tremendous economic and military might the U.S. can bring to bear. On the other hand, it means the U.S. has to take on many more problems than most countries do. This is a vulnerability, one that Russia can use to its benefit to try to push back against what it sees as a United States that is encroaching needlessly on Russia’s sphere of influence. As we look at Russia’s highly varied and extremely active foreign policy moves of the past month, it becomes clear that Russia is trying to use that vulnerability against the U.S., interfering where it can to gain leverage to disrupt U.S. strategy in other parts of the world.
Agent of Chaos
The most prominent area where the U.S. is focused right now is North Korea. Russia can’t shape events on the Korean Peninsula, but it can try to prevent the U.S. from reaching any kind of resolution that Washington would consider a strategic success. In August, Russia donated some 800 tons of grain to North Korea. During the first week of September, right after Trump accused South Korea of appeasement, South Korea’s president traveled to Russia for a multinational forum and, in a joint press conference with Putin, said Moscow and Seoul saw eye to eye on how the North Korea nuclear issue could be solved. In the U.N. Security Council, Russia has joined with China to limit the efficacy of sanctions, and it has gone out of its way to respond to some of Trump’s incendiary comments on North Korea, publicly questioning whether U.S. allies like South Korea and Japan ought to trust the U.S. any longer. Not to mention the many high-level meetings that have occurred between North Korean and Russian diplomats.

Russia just this week held naval drills with China in the Sea of Japan and the Sea of Okhotsk. These naval exercises are the second part of China and Russia’s 2017 Joint Sea Program, and as they took place, the U.S. and South Korea were carrying out naval exercises of their own in the region. Military exercises in and of themselves don’t mean much geopolitically speaking, and there is still a great deal of distrust between Russia and China. It’s not like Moscow and Beijing are entering into a formal alliance. That said, Russia and China share an interest in weakening the U.S. position on the Asian mainland, and there are things they can work together on to do just that. The U.S. and South Korea have held joint military exercises for decades, but that didn’t prevent North Korea from developing nuclear weapons. Chinese and Russian naval exercises in this part of the world at this particular moment are a powerful signal to the region that there is more than just one game in town.

Consider also Russia’s activities in more far-flung and less geopolitically relevant parts of the world. Russia has cultivated a relationship with Venezuela going back to the times of Hugo Chavez. As Venezuela slowly descends into anarchy, Russia has been increasing its involvement, providing Venezuela with lifelines in the form of loans to keep the government solvent. This isn’t simple generosity – Russia is picking up shipments of crude oil and shares in state-owned oil assets in return. And unlike with its grain diplomacy in North Korea, Russia prefers to get paid for the 600,000 tons of grain it will be delivering to Venezuela in the next year, rather than simply offering it as a donation. Still, the motive here isn’t ultimately about profit; it’s about Russia involving itself in the Western Hemisphere and propping up a regime that U.S. administrations of both parties have struggled to deal with. The character of the regime in Caracas matters little to Russia so long as Caracas is at odds with Washington.

Or consider Russia’s involvement in the Middle East, the one place where the U.S. and Russia have been able to cooperate in recent years. Earlier this week, Russia, Iran and Turkey agreed – without any input from the U.S. – to set up a safe zone in Syria, covering most of Idlib province and divided into different areas of responsibility run by each country. The U.S. is focused on destroying the Islamic State, and while the U.S. and Russia work together on that goal, Russia has an eye toward influencing what happens in Syria after IS has been destroyed. From its relationship with Syrian Kurdish groups to its support for the Bashar Assad regime and its continued deployment of limited but effective forces on the ground, Russia is ensuring that it will have a say in the future of the Levant. Syria itself is of little geopolitical significance to Russia (or the U.S., for that matter); what Russia wants is for the U.S. and others to treat it as an equal in order to make the country appear more powerful, at home and abroad, than it really is.
Tanks take part in the joint Russian-Belarusian military exercises Zapad-2017 (West-2017) at a training ground near the town of Borisov on Sept. 20, 2017. SERGEI GAPON/AFP/Getty Images
Plan for the Worst
Meanwhile, Russia and Belarus are holding military exercises known as Zapad, or “West,” in Belarus. These exercises have spooked the region – on Sept. 20, Estonia’s defense minister said, for instance, that the drills were Russia’s preparation to intervene in Belarus. The Belarus issue should not be confused with the foreign policy moves mentioned above. Russia’s control over its traditional buffer zones has shattered. In contrast to the Middle East intervention, these buffer zones are a core Russian security imperative. The Baltics are already in the Western camp, and most of Ukraine is now under the control of a pro-West government that is regularly flirting with receiving new and advanced weaponry from the United States. Belarus is the only country in the buffer zone upon which Russia can still unequivocally depend. Belarus, for its part, has in recent years attempted to move closer to the West, but its economy is still far too dependent on Russia for such moves to be taken seriously.

But governments must hope for the best and plan for the worst. Russia can’t assume Belarus will remain in its camp forever, particularly as Russia’s economic weakness diminishes its ability to buy allegiance. Russia is therefore using these exercises not just to demonstrate its power but also to test how far its military has come since the Georgian War (which revealed serious deficiencies in the Russian military), and how much further it has to go in order to defend what parts of the Eastern European buffer zone are left to it against what it sees as Western encroachment. This is where the roles shift, and where Russia becomes vulnerable if the U.S. were to involve itself more in places like Belarus, whether through nongovernmental organizations or formal policy statements.

Russia cannot shape outcomes, but it can complicate and prolong various conflicts, the goal being to keep the U.S. spread thin, fighting small fires around the world. The more the U.S. is tied down in smaller conflicts that don’t affect Russia directly, the more freedom of action Russia has in its immediate periphery to hone its capabilities and defend its interests without having to worry about a potential U.S. response. As Russia makes headlines, keep in mind that often its goal is to distract the U.S., and that the broad scope of Russia’s moves actually belies Russia’s inability to secure its own interests on its own terms.

Russia is playing a weak hand – but it is playing it very well, and unlike the U.S. or even the Soviet Union, there are simply few things in the world that are of existential importance to Russia. The U.S. tries to be everything to everyone, everywhere. Russia settles for complicating U.S. designs and defining its goals very narrowly. When properly executed, this makes Russia a formidable challenge to the U.S. despite the large gap in hard power between the two.

Americans Are Richer; Why Are They Still Cautious?

Household wealth hit a new high, but that hasn’t made Americans more willing to spend

By Justin Lahart

Ford Mustang GTs sit in a car dealership lot in Matteson, Ill. According to Federal Reserve data, U.S. household wealth has reached a record level, but consumer spending has been tepid, and people have been far less willing to tap wealth. Photo: Daniel Acker/Bloomberg News

Getting richer doesn’t make people spend like it used to. That should give the Federal Reserve less to worry about when it comes to consumers, but more to worry about when it comes to asset prices.

Lifted by rising home prices and a buoyant stock market, U.S. household net worth reached a record $96.2 trillion in the second quarter, the Fed reported Thursday, up $1.7 trillion from the first quarter. That compared with $68.2 trillion a decade earlier, just before the recession hit.

The wealth-to-income ratio hit a new high of 670%.

But if households are feeling flush they aren’t acting like it. Consumer spending has been tepid, and people have been far less willing to tap wealth to fuel spending than they used to be. Bank of America Merrill Lynch estimates that for each dollar gain in housing wealth, people increase their spending by just two cents, versus five cents in the mid-1990s. For stock gains, the figure has slipped to one cent from four cents.

Net worth as a share of disposable income (1960-2017)

There are few likely reasons for the change in behavior. First, people don’t put as much trust in the staying power of wealth gains. The big stock market drops following the dot-com bust and the financial crisis are hard to forget, and the housing bubble ended the old notion that home values are safe. Second, a greater share of U.S. stock market and housing wealth is concentrated in the hands of the rich, who don’t boost their spending in response to wealth gains as much as other people do. Finally, tighter lending standards have made it more difficult to tap into housing wealth than it was before the financial crisis.

During the early years of the recovery, as asset prices rebounded but the economy only trudged along, the Fed probably wished Americans weren’t so hesitant to spend their wealth. But now, with the economy healthier and the Fed tightening, the central bank is probably pleased that it does not have to rein in reckless consumer spending, points out Merrill economist Michelle Meyer.

The downside is that is that if consumer behavior and asset prices continue to diverge, the Fed could face some difficult choices. Say that consumer spending remains muted, the economy grows at the same steady pace and inflation remains low as a result. And say that stock prices keep on rising, stretching valuations to the point where they look frothy. Under those circumstances, should the Fed keep rates steady, and risk a bubble? Or raise rates to cool asset prices, and risk pushing consumer spending and inflation dangerously lower?

Making Economic Sanctions on North Korea Work

Yasheng Huang

CAMBRIDGE – Last week, in a brazen rebuff to tough new United Nations sanctions, North Korean leader Kim Jong-un’s regime fired a ballistic missile over the northern Japanese island of Hokkaido – its second launch over Japan in less than three weeks. But, far from indicating that sanctions don’t work, Kim’s move shows that they still aren’t tough enough.       

The latest sanctions cap oil imports, ban textile exports, and penalize designated North Korean government entities. Following Kim’s response, sanctions should be tightened even further, to stop all trade with North Korea, including halting all fuel imports.
North Korea is one of the most insular countries in the world. That insularity is a curse for the long-suffering North Korean people, but an advantage for a sanction-based strategy, because only one country is needed to make it work: China.
From an economic perspective, China is the only country that really matters to North Korea, as it controls about 90% of the North’s foreign trade and supplies almost all of its fuel. Yet China’s economy would barely register the effect of new sanctions: North Korea’s annual GDP, at a meager $28 billion, constitutes little more than a rounding error for its giant neighbor.
The lack of viable commercial alternatives and the massive asymmetry of power between North Korea and those imposing sanctions mean that a stricter sanctions regime would push the country into a corner. The question is whether economic hardship would induce North Korea to change its nuclear policy. Though it is impossible to say for sure, a look at the economics of North Korea’s nuclear program suggests that it might.
Contrary to popular perception, nuclear arms are weapons of the poor – extraordinarily cheap compared with conventional armaments. In fact, it was this rationale that drove the Soviet Union’s massive nuclear buildup: Soviet leaders, recognizing that they could not compete with the much wealthier United States’ conventional weapons, focused their country’s limited resources on creating a potentially devastating nuclear arsenal.
Likewise, North Korea’s focus on nuclear, rather than conventional, weapons may be enabling it to minimize the tradeoff between guns and butter. Indeed, there are reports of some vitality in the North Korean economy, with markets full of goods and new buildings under construction. Tighter sanctions are therefore needed to increase the economic price that the regime must pay for its nuclear program.
Even if North Korea does not change its policy, total economic isolation may bring about an end to its nuclear program, by sowing internal discord and, ultimately, triggering the regime’s collapse. Yet China hopes to avoid precisely this outcome – which is a key reason why it has so far refused to escalate sanctions further.
China worries that the collapse of the Kim regime would fuel a major refugee crisis, with millions of Koreans pouring across its border in search of food, shelter, and security – and imposing heavy economic and social costs on China in the process. Moreover, Chinese leaders fear the loss of the North Korean buffer separating China from US troops stationed in South Korea. Given the widespread belief in Chinese policy circles that the US secretly hopes to re-fight the Korean war and establish a single US-allied Korea on China’s border, the potency of this concern should not be underestimated.
US President Donald Trump’s administration understands the central importance of China to any strategy to rein in North Korea’s nuclear ambitions. But, so far, the US has , such as halting $650 billion in bilateral trade, to persuade China to cooperate. This is not a stick, but a boomerang – one that will hit China and immediately return to smack the US.
What is needed instead are carrots. Persuading China to isolate the North economically will require the international community to establish some agreement regarding how regime collapse would be handled, with an eye to allaying China’s key concerns.
For starters, the entire international community, but especially the US, must explicitly pledge not to attempt to change the nature of the North Korean regime. That means that if the Kim regime collapses, the US will not pursue reunification. Instead, China should exercise primary political custodianship of North Korea in the event that a political vacuum emerges. Come what may, US and South Korean troops would not cross the 38th parallel.
Persuading China to impose potentially regime-destroying sanctions will also require economic pledges, with the entire international community – especially the US, Japan, and South Korea – committing to share the mammoth costs of sheltering refugees and rebuilding North Korea’s economy. While China would inevitably cover a substantial share of these costs, owing to its geographic proximity and historic ties to the North, it needs reassurance that it would not be left to shoulder the burden alone.
Admittedly, this approach is somewhat reminiscent of the one taken at the 1945 Yalta Conference, where leaders of the Soviet Union, the United Kingdom, and the US carved out geopolitical spheres of influence in post-World War II Europe. Moral and ideological objections, therefore, are to be expected.
But it’s time to get real. The nuclear threat posed by North Korea is serious, immediate, and requires a bold response. This is not the time to be constrained by conventions and ideology; it is the time to do whatever is needed to defuse nuclear tensions and protect the lives of those in the Kim regime’s crosshairs.
China is the only country with the power to force North Korea to change its nuclear policy.
Convincing the Chinese to wield that power must be world leaders’ top priority.