Irreverent Economics

my piece on voxeu.org today

Bank capital has emerged as a key element in the post-crisis financial regulatory reforms. Basel III is now likely to include a 7% equity-to-risk-weighted-assets capital requirement.

7% was a compromise. Some countries wanting more capital now intend to implement stricter standards unilaterally. This is making some of the others unhappy, and a bitter debate has erupted within the EU on whether individual EU member countries should be allowed to require more capital than the Basel III, and hence EU, minimums.

Capital and bank size in the EU

Measured by total assets of domestic banks, the three largest banking nations in the EU in June 2010 were Germany, the UK and France, in that order. The banking statistics come from the ECB. If we divide by GDP, the UK is largest amongst those three at 464%, followed by Germany at 337% and France at 336%. Judging by these numbers, the UK does not seem to be the outsized banking nation it often is made out to be. By including foreign banks, the numbers for France and Germany increase slightly, but the UK goes to 658%.

The ECB provides several different ways to look at bank capital. By taking the measure most relevant to the financial markets during the crisis, tangible equity/tangible total assets, the UK has the best capitalised domestic banks at 4.2% amongst the three countries, followed by France at 3.8%, with Germany having the least capitalised banks at 3.1%.

Minimum capital and Basel III: Some countries view the 7% as insufficient

In the ongoing debate on Basel III, one of the most contentious issues has been the level of bank capital. The Basel III minimum equity capital levels have been set at 7% of risk-weighted assets. Some countries have indicated they want higher minimum capital levels. One might think that the countries making the biggest public noises about problems of excessive risk-taking and speculation would be exactly those demanding higher capital. After all, higher capital directly reduces leverage and risk taking, increasing safety.

Surprisingly, it is the opposite.

• The main champions for more capital are the US, UK and Switzerland,
• The opposition is led by Germany and France.

In the US, an additional 3% may be imposed (Wall Street Journal 2011). Within Europe, the UK has similarly signalled its willingness to do the same (BBC News 2011). That would need to be allowed by EU regulations. France and Germany would like the minimum 7% also to be the maximum, following the so-called “maximum harmonisation” principle. Their public reasoning seems to be based on the public’s belief that their banks weathered the crisis better than the Anglo-Saxon banking nations. However, there is a lingering suspicion that something less straightforward is behind their stance. Germany and France may be opposing higher capital requirements because of hidden vulnerabilities in their banks’ assets. This would both make their capital ratios worse than reported above and the banks more fragile. By contrast, countries wanting more capital already might have stronger banks, partly because they have been more forthcoming in forcing their banks to recognise dodgy assets.

The maximum harmonisation principle for capital is misguided

The maximum harmonisation principle for capital would be sensible if the EU were a single financial market, homogeneous in national attributes such as bankruptcy laws and having a single European supervisory agency. In such a world, variable capital standards undermine the principle of a single financial market.

This, however, is based on a utopian view of European financial markets. After all, the EU does not have a political union, enabling a single EU supervisory agency, nor common bankruptcy laws. Consequently, the composition of assets, and treatment of assets in bankruptcy will be different across borders.

Furthermore, with each state having independent budgets, government policies and development levels, the nature and importance of banking will vary significantly across member states.

Looking at total banking assets over GDP, the relatively smallest banking state is Romania at 64% and the largest is Luxembourg at 1,964%, followed by Ireland at 929% and Cyprus at 928%. For the largest banking states, the financial sector is a significant generator of systemic risk and contributor to the business cycle. Those forces are not as strong in countries with smaller banking sectors, especially where the banks are mostly foreign.

A country with a large banking system needs different approaches to supervision than a small banking state. It needs more protection from financial turmoil and hence it would be prudent for it to require higher capital levels.

Indeed, it is sensible to vary capital levels with the relative size of the banking sector. For these reasons, the maximum harmonisation principle for bank capital is not advisable.
Those wanting low capital may have weak banking systems

The same countries that led the opposition to higher capital standards in the Basel III negotiations now oppose variable capital requirements in the EU, Germany and France.
I suspect they fear that allowing countries to impose more stringent capital standards would expose the weaknesses of their own banking systems. If an important banking nation successfully implements relatively higher capital standards, it directly signals that country’s relative banking strength and a desire not to support the banks in a crisis.

Perhaps, the real reason for the French and German opposition to variable capital standards can both be found in weaknesses in those countries’ bank assets and their willingness to use taxpayers’ money to bail out the banks.

Conclusion

The financial crisis demonstrated the need for improving capital standards, with Basel III a step in the right direction. Countries with large financial systems need to have the freedom to impose stricter controls on risk taking than is the norm. For these reasons, an EU maximum harmonisation for bank capital would be the wrong step.

References

BBC News (2011). “EU block on making banks safer”, 16 June.
Wall Street Journal (2011). “Lenders Dig In on Rules”, 16 June.

I suspect that the resolution of the Icelandic banking crisis in October 2008 might make it into the textbooks as an example of how not to deal with a banking crisis.

The standard wisdom has it that failing banks should be split up into good banks and bad banks, where problem assets are hived off  into the bad bank. The idea is that the good bank can then provide regular banking services unencumbered by all the duff assets. The best example of this was provided by Sweden in its resolution of the early 1990s banking crisis.

The Icelandic authorities, demonstrating their “typical not invented here syndrome“, decided to find their own approach without any apparent expert input, and split the three failing banks along national lines, i.e., foreign operations and Icelandic operations. This ignored the fact that both the domestic and foreign part of the banks had failed.   After the split Iceland was saddled with three failed banks and three crippled banks. The result is that Iceland is missing today a key requirement for economic recovery — a well functioning banking system.

Of the three crippled banks, two have been transferred to creditors of unknown provenance and the last, Landsbanki,  remains in state hands pending the resolution of Icesave. All three suffer from serious debt overhang, preventing them from acting as a bank should, providing risky lending to viable companies and startups.

All the banks are now very profitable, one reporting 18% return on equity, obtained by spreads that would be the envy of every bank in Europe. Still they are not lending as they should, (they are though getting better after being slapped by the PM).

In theory, this problem could be remedied by creating special reserves  for dealing with problem assets, effectively implementing a bad bank–good bank model within the existing institutions. That is apparently not possible for some obscure accounting and tax reasons.

Instead, the banks are forced to have the capital adequacy ratio of 16%. Yes 16%, you heard me right. This is unheard of. The rest of the world is happy with 8%. Even Ireland with its failed banks is not contemplating such an extreme number. Still the banks enjoy a 18% return on all that equity!

Again, this is a novel invention by the Icelandic authorities. In most countries, the function of bank capital is to meet unexpected losses and perhaps contain credit growth. In Iceland, they seem to think that the purpose of bank capital is to meet expected losses. In other countries they would use reserves for this purpose.

The consequence of using such an inappropriate instrument is the  prevention of credit expansion. The most profitable and the socially desirable time to increase risky bank lending is exactly at the bottom of a crisis. The Icelandic authorities are doing what they can to achieve the opposite outcome.

Of course, this would a great time to start a new bank, but with capital controls its hard to attract foreign investments, and the locals prefer to stay liquid.  Besides, surly they would keep the 16% capital ratio for a new bank — we can’t discriminate.

In the end, this means that the recovery of the Icelandic economy is being held back to ensure banks are profitable enough to make up past losses.  Icelanders have been congratulating themselves on mostly escaping having to bail out their banks . Is that now happening through the back door?

We might expect those countries who have expressed the biggest unhappiness about the excesses of the financial system before the crisis to be the ones campaigning for its soundness today. Guess again.

We hear out of the G20  meetings in Korea this weekend that the biggest opposition to topping up the capital requirements for the systematically important banks comes from…

Drumroll…

Germany, France and Japan

go figure.

For the past few years all the pundits and all the governments have been telling us that finance was too risky. That it was high time to curtail risk taking. Many many big  words from various  European luminaries to that effect. like

I guess they changed their minds. A couple of weeks ago we got an announcement from the Basel Committee  saying that banks would not  really be required  to increase their capital for the next eight years. So what does this mean (besides being a manifestation of the banks superb lobbying ability)?

It says that our governments have decided that after all they don’t want the banks to reduce risk. After all is said and done we are fine with the bank’s risk level. Risk before the crisis really was not excessive. It is  back to status quo in banking.

Hey guys, think of the old song “It’s Never too Late to say I’m Sorry”

There was a G20 meeting in Washington this weekend, and one topic was capital.

As always, countries fall into blocks, but, casually at least, the membership is surprising.

The debate is about whether to substantially increase capital,  limits what counts for capital and touch liquidity rules. A sensible direction, one would think.

Surprisingly, those in favor are UK, UK, and Switzerland. Those opposed Germany, France and Japan. Why surprisingly, because one might have thought that the opposed are those who normally favor more regulation as a response to the crisis.

But then, those in favor are those who have been more forthcoming in making banks recognize problems. Could it be, just could it be, that evergreening is the real motivation by those opposed? After all, the word on the street is that they have some pretty large losses hiding in the bowels of their banks.