(Adapted from Fixing Banks - Part I Industry Commentary of the Global Association of Risk Professionals)
Banks are junk credits.
Such is one conclusion of our previous post Junk Banks?! A government’s
guarantee of its banks is expensive precisely because the underlying banks are
junk. One way or another, the
taxpayers and citizens bear the large expense of the government guarantee for
banks. Yet it would be disastrous
for a country to lose its payment system through the near-simultaneous failure
of several large banks.
Though not a “solution” to this quandary of whether and how a
government should support its banks, the obvious premise for a solution is that banks should have much lower
dependence on the government guarantee.
That is, underlying bank risk should not be “junk.” To the extent that banks have very low
risk of failure on a stand-alone basis, they would have low risk of government bailout.
We divide proposals for “fixing banking” into three categories: “Nibble the Edges;” “Dramatic Change
Inside the Box;” and “Banking Re-Boot into Safe Mode.” All three have advantages and
disadvantages. The first option is
easiest to implement and is the current course of global governments and
regulators. Unlike this first
option, the second proposal would be highly effective. While straightforward to implement,
this option #2 is controversial and requires an old-fashioned political battle
that could go either way. Finally,
we consider the third option to be the “best answer.” But being right and winning arguments are not the same
thing. Convincing a majority to
adopt this option #3 will be challenging.
In this Part I, we discuss only the “Nibble the Edges” alternative.
Option #1: Nibble the Edges
When human organizations confront failure and must take remedial
action, the prevailing attitude is often to make as few changes as
possible. The failure demonstrates
the imperative for change. Yet all
organizations have vested interests that abhor change. The result is that such institutions
grudgingly concede only the incremental modifications that will supposedly
eradicate future failures.
Global governments, bank regulators, and bankers constitute the
large “human organization” that must address the failure of government policy,
bank regulation, and banking of 2008 to the present. True to form, this organization has enacted and proposed
minimal change to banking operation.
Beyond the small number of significant banks (such as IndyMac, Washington Mutual, Lehman
Brothers, and Laiki Bank) that
governments permitted to fail without bailouts for all creditors, almost all
players remain the same. Leading
politicians, regulatory heads and staff, bank executives – they’re all the same
people. Banks and governments
still retain their political bargain as
we described in Banks and Political Bargains. It is not an exaggeration to say that
the only reactions to the Credit Crisis are moderately higher capital
requirements, the possibility of improved bank liquidity, a potential loose and
discretionary limit on simple balance sheet leverage, and central banks’
administration of “stress tests.”
(As support, the Basel Committee
on Banking Supervision proposes nominally constructive bank liquidity
requirements at Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring
tools, January 2013. The
article M. Auer and G. von Pfoestl, “Basel
III Handbook,” Accenture, 2012,
shows the increased capital requirements from Basel II and so-called Basel 2.5
to Basel III in figures 2 and 3.
Though there are many “moving parts,” we quote just one aspect here: minimum Tier 1 capital increases from
4% to 6% of risk-weighted assets.)
The great advantage of “nibbling the edges” in this manner is that
the changes are politically achievable.
Political leaders can show that “they did something.” Regulators get more apparent control
over banks, larger budgets, and a longer checklist of activities. Bankers retain their lucrative careers
in exchange for following a modified set of rules. It stands to reason that increasing capital requirements
will lead to some beneficial reduction
of bank default risk. Thus, this
edge nibbling should have a positive near-term impact if one ignores the
increased and incalculable inefficiencies of the new regulation.
The glaring disadvantage of this approach is simply that there is no
real change. With the eraser at
the end of the pencil, regulators are removing old capital requirement values
and writing in some new and higher values. The direction is right, but there’s no rhyme or reason to
the old or new numbers other than what emerges from a global political
agreement. As a further criticism
of the solution, there is not even a cogent statement of the problem. That is, regulators and politicians do not state a goal of a
target bank stand-alone default probability or expected loss to taxpayers. Without a clear problem statement,
there can be no solution and no intelligent discussion of a solution.
In Parts II and III of this series we will describe the “Dramatic
Change Inside the Box” and “Safe Mode” alternatives to “Nibble the Edges.” Part II will focus on the proposal of Admati
and Hellwig to require multiples of additional equity capital. Part III will explain the calls of
Kotlikoff, Wolf, Kay, and many others for stark reinvention of “fractional
reserve banking.”
