The threat of the “volatility junkie”

This is Martin Wolf’s response* to Andrew G Haldane’s “Control rights (and wrongs)” Wincott Annual Memorial Lecture, on October 24, 2011

In this lecture, Andy Haldane, executive director for financial stability at the Bank of England, provides a compelling account of the development of western – above all British banking – over the past two centuries. He demonstrates the consequences of a progressive divorce between who controls the banks – shareholders and managers – and who bears most of the risks – society at large and, in particular, taxpayers.

Mr Haldane shows that each step along this road to ruin seemed reasonable, even inescapable. Yet the journey has ended up with over-leveraged behemoths that are too big to fail and, increasingly, too big to save.

Between one and a half and two centuries ago, it was common for equity to account for half of a bank’s funding and liquid securities to account for as much as 30 per cent of its assets. Financial sector assets accounted for less than 50 per cent of UK gross domestic product and the largest banks had assets of less than 5 per cent of GDP.

Fast forward to today. Banks’ leverage ratio is in the neighbourhood of 20 to 1 and has been much higher, quite recently. Banking assets reached five times GDP in the UK, just before the crisis. After the crisis, they are concentrated overwhelmingly in a small number of too-big-to-fail institutions.

As leverage rose, so did returns on equity, from the low single digits to close to 20 per cent. “Arithmetically”, notes Mr Haldane, “virtually all of this increase in equity returns can be explained by increased leverage.” Necessarily, this also means increased volatility: “While the variability of banks’ returns on assets has roughly trebled over the past century, the variability of returns on equity has risen between six and sevenfold.”

In short, we have moved from relatively safe, small banks within a small banking system to relatively unsafe, giant banks within a huge banking system.

So what put us on this journey? The answer, Mr Haldane states, is changes in incentives. Governments have wanted banks to be bigger and take more risk – and they have succeeded, beyond their wildest nightmares.

In the beginning, liability was unlimited. At the end, liability was strictly limited. In the beginning, managers and owners were one and the same. At the end, managers were hired hands, with brief tenures, rewarded for raising the return on equity, regardless of risk. In the beginning, the tax regime did not affect the structure of finance. At the end, it powerfully rewarded increases in leverage. In the beginning creditors knew they could lose their money. At the end, creditors had good reason to expect they would not.

Given the capping of downside risk by limited liability, the incentive is to raise the volatility of returns. As Mr Haldane remarks, “put more directly, joint stock banking with limited liability puts ownership in the hands of a volatility junkie.”

Not only are banks themselves made riskier, so is the economy, since the balance sheets of the banks are so closely interwoven with those of everybody else. Recognising this, the Independent Commission on Banking, of which I was a member, concluded that the median cost of crises was the equivalent of 3 per cent of GDP, in perpetuity (see page 124 of this report).

A significant weakness is the inability to impose losses on creditors during a crisis. At the limit, therefore, the liabilities of banks become off-balance-sheet government debts. Mr Haldane argues that “For UK banks, . . . the implicit subsidy amounts to at least tens of billions of pounds per year, often stretching to three figures. For the global banks, it is at least worth hundreds of billions of dollars per year, on occasion four figures.” The economic result, meanwhile, is an enormous increase in leverage in the economy.

Yet the subsidy does not benefit most creditors, since they merely receive a lower return. Even long-term shareholders appear not to gain: the purchaser of a portfolio of global banking stocks 20 years ago is sitting on real losses today. The beneficiaries of the subsidy are short-term shareholders skilled at trading volatility and, of course, managers with remuneration linked to returns on equity or share options. Mr Haldane describes the resulting emphasis on short-term returns as the “myopia loop”.

Mr Haldane discusses four ways of changing incentives:

  • The first is to raise equity requirements substantially. There has been some progress in this direction. But it probably does not go far enough. David Miles, a member of the Bank of England’s monetary policy committee, with two co-authors, suggests that the optimal capital ratio would be 20 per cent of risk-weighted assets. Such a shift would impose private costs, because of the favourable tax treatment of debt. The answer is to change that tax treatment, by making a normal return on equity tax deductible or, alternatively, withdrawing the tax deductibility of debt.
  • The second approach is make debt more equity-like. Mr Haldane argues that so-called bail-in debt would prove too costly, because of the damage done by bankruptcy. US experience suggests that this need not be the case. But I agree that the point of bail-in should be determined by market-based measures of capital adequacy. More broadly, bail-in debt can be accepted only if regulators believe they can carry out the conversion into equity, in a crisis. Otherwise, equity ratios should be raised.
  • A third possible reform is via changes in control rights. It is possible to envisage radical changes to voting rights, for example, that might give some votes to some creditors. Mr Haldane describes this as a hybrid of the mutual and joint-stock models.
  • A fourth possible reform, suggests Mr Haldane, is to change the target return from one on equity to one on assets. That would certainly have a powerful and attractive impact on incentives.

I think these are all attractive ideas. What would I like to see added?

My first suggestion is to reconsider limited liability, at least for investment banks. The advantages of partnerships are very great.

My second suggestion is to consider more carefully the split between retail and investment banking suggested by the ICB. The biggest benefit, in my view, is that it should mitigate time-inconsistency. Should a pure investment bank get into trouble, it would be possible to let it fail, provided the country has a resolution authority which is able to wipe out shareholders and longer-term creditors, while winding short-term trading down smoothly. Since winding up retail banks would be more disruptive, the ICB suggests a higher capital ratio, as extra insurance.

No paper is complete. This one has several important omissions.

  • The first omission concerns the long-term macroeconomics of leveraged economies. Defenders of the status quo would argue that any subsidies benefit the economy by increasing credit supply and so economic growth. The evidence is, in fact, that the hugely expanded leverage of the economy has, instead, made it far more fragile, without generating any increase in long-term growth.
  • The second omission concerns the short-term macroeconomics of de-leveraging. Today, we find governments caught between a strong suspicion that the economy should be deleveraged and a fear that the result will be an even longer and deeper economic contraction. In short, they want banks both to lend less and lend more. How is this to be reconciled?
  • The third omission concerns so-called shadow banking. There is little point, in making banks safer if the financial system as a whole becomes less safe.
  • The fourth omission concerns the international context. The UK is part of global and European regulatory regimes. The question, then, is whether it is possible for the UK to set its own regulatory rules, without international arbitrage.
  • The fifth omission is the most profound: the question of error. Mr Haldane works within the paradigm of orthodox economics. In this view, if things go wrong, the explanation has to be bad incentives. But he himself provides strong evidence, in the form of credit default swaps on the banks’ debt, that markets suffered from “disaster myopia”. Investors did not misprice risk because of a belief that they would be bailed out, since the spreads rose when the bail-outs began. They mispriced risk because they failed to recognise it. That has profound implications.

Andy Haldane’s paper is both illuminating and important. It describes a road to hell paved with good intentions. The incentives generated by limited liability, tax-favoured debt, explicit guarantees for depositors and implicit guarantees for other creditors have resulted in a world in which a tiny sliver of equity gives control over huge balance sheets. Managers, in turn, have managed banks to give high, but risky, returns on that sliver. On this basis, they they have been extraordinarily well rewarded in good times and allowed to keep their gains in bad times.

This is banking for risk-junkies. We have barely survived this time. Next time, we may not.

* This is an edited version of Martin Wolf’s comments on Mr Haldane’s paper at the lecture. The full version will be available on the Wincott Foudnation website.