How not to reform financial markets

Just how weak is the UK government’s recent white paper Reforming financial markets? Imagine one small spoonful of tea leaves in a teapot the size of an adult beer barrel. That’s how weak.  I will focus on four areas of weakness: (1) the continued subsidisation of the banking sector’s cost of capital, (2) the failure to address the too big to fail problem, (3) the unholy mess that is the UK’s Tripartite Arrangement, and (4) the foot dragging as regards the creation of new macro-prudential instruments.

(1) Ending the subsidisation of the banking sector’s cost of capital

The recent crisis has re-confirmed the view that unsecured creditors of large banks are de factoguaranteed by the state.  Bank shareholders, or at any rate the holders of tangible common equity (tce), are at risk, but from the holders of subordinated bank debt on up, the credit risk is socialised by the state, free of charge.  This subsidises the cost capital to banks – a weighted average of the cost of internal financing through retained profits, equity finance and debt finance.

This has two consequences.  First, the size of the banking sector (measured by value added, employment, balance sheet size)  is excessive.  There is too much intermediation through banks.  I know that the government tells us that both as regards time series and cross-country evidence, the size of the UK financial sector today (about 8 percent of GDP) is not exceptionally large.  That may well be so, but this is of course quite consistent with the proposition that it is still too large. Second, since the subsidy is through the unsecured debt component of bank finance, it encourages excessive leverage, thus raising the risk that the state will indeed be called upon to bail out the bank and its unsecured creditors.

The solution to this problem of excessive banking sector size and leverage resulting from the free guarantee provided the unsecured creditors of the banks is clear: eliminate the guarantee.  The special resolution regime (SRR) created in the Banking Act of 2009 for commercial banks and building societies should have the property that no public money goes into a bank (as capital or as guarantees), until all unsecured creditors have been converted into shareholders (all bank unsecured debt converted into tce).  After that, the SRR should be extended to include investment banks and all other highly leveraged institutions with significant asset-liability mismatch, that are deemed to be systemically significant, severally or jointly.

(2) Breaking up banks and taxing bank size

HM Treasury are quite comfortable with large, complex and conflicted financial institutions.  The white paper does recommend that all systemically important financial institutions be required to write a will and keep it up to date.  This ‘will’ would contain a blueprint for restructuring, breaking up or liquidating the bank in the event of insolvency. The Bank of England is supposed to vet the quality and appropriateness of these insolvency plans, which should allow a failing back to inter the SRR on a Friday evening and for something viable and sensible to emerge again the next Monday morning.

The white paper appears to jump from the correct observation that size is not a necessary condition for systemic importance and bail-out prerogatives, to the incorrect conclusion that size is not a problem.  Financial institutions can be too big, to interconnected, too complex, too international and too politically connected to fail.

Much of the complexity and not a small part of the cross-border nature of many banks is part of a deliberate strategy to make the bank and its operations opaque and incomprehensible to regulators, supervisors, tax authorities, shareholders and competitors.  Such regulatory arbitrage and tax arbitrage-driven complexity and internalionalisation is socially inefficient.  It will be discouraged by the ‘will’  these institutions will have to file in the future.

It is possible that, because they play a pivotal role in the inter-bank intermediation system, some small banks, or clusters of small banks are systemically significant and too important to fail.  I accept the point in principle.  This does not, of course, provide an argument for trying to restrain the growth of banks to enormous size.  Four simple instruments are available.  The first is to tax bank size by making the required capital ratio an increasing function of bank size, after a certain minimum size.  The second is to split narrow banking (deposit taking and lending to non-financial corporates and households) from other banking activities.  The third is to break up existing big banks along lines of manifest conflict of interest.  The fourth is active anti-monopoly or anti-trust policy.

(3) Sorting out the Tripartite Arrangement

Financial stability can only be maintained or restored effectively through the close cooperation of the monetary authority, the regulatory/supervisory authority and the fiscal authority.  The monetary authority is the source of the ultimate unquestioned liquidity – central bank money, that is, coin and currency and reserves with the central bank.  Its resources are required for liquidity support through open market operations, the discount window, lender of last resort interventions or market maker of last resort interventions.  The regulator/supervisor (I roll them together, although the regulator makes the rules and the supervisor enforces them) can instruct financial institutions, other  participants in financial arrangements and financial market participants in general to do certain things and to desist from doing certain other things.  The fiscal authority has the non-inflationary long-term deep pockets (aka the tax payer) necessary whenever capital inadequacy is the issue, including when insolvency threatens.

The central bank as lender of last resort and market maker of last resort should have primary macroprudential responsibility and powers.  That means it should have responsibility (1) for the stability of the financial system as a whole, (2) for each highly leveraged financial institution that is severally (or jointly with others) systemically important, (3) for all systemically important financial markets and (4) for the key payment, trading, clearing, settlement and custodial platforms.

The fact that the Holy Trinity of the monetary authority, the regulatory/supervisory authoritie and the fiscal authority has to be involved in financial stability, that is three functions or powers, says nothing about how many institutions should be involved.  There could be just one institution involved – the Treasury.  Between the nationalisation of the Bank of England and 1997, the Bank of England was just the liquid subsidiary of the UK Treasury.  The Bank had the supervisory responsibility for the banking sector, but as the Treasury controlled the Bank, there effectively was a unitary tripartite authority.

You could also get the monetary authority out of the financial stability business, or at least out of any active role, by assigning the lender of last resort and market maker of last resort functions to the supervisor-regulator.  This could be achieved in the UK by giving the FSA an uncapped, open-ended overdraft facility with the Bank of England, guaranteed by the Treasury.  The active decisions on which bank to support with funding liquidity or which instruments to support by providing market liquidity could then be made by the FSA.  As the FSA has no macro-prudential experience or knowledge, this would result in a rather nasty learning curve.  The (short) tradition of the FSA is that of an institution of bean counters, lawyers and box tickers, not of an organisation staffed by persons with macro-prudential competence and interests.  The current Chairman of the FSA, Adair Turner, is trying to change the culture of the place, but even if he ultimately succeeds, the UK economy cannot afford to wait for this transformation to be completed.

It therefore clearly makes sense to assign the regulatory/supervisory responsibilities, powers and instruments for macro-prudential stability, other than the fiscal competency, to the institution whose natural habitats are the economy-wide and world-wide money markets and the provision of funding liquidity and market liquidity. That means that the Bank of England should have the final say in macro-prudential management issues, as long as the tax payer is not involved.  When recourse to the fiscal powers of the sovereign is involved, the Treasury has to have the final say.

HM Treasury has moved in the opposite direction.  In the white paper it proposes to give the FSA a statutory financial stability mandate and associated powers that are, where it matters, superior to the Bank of England’s financial stability powers.  I believe that the FSA should not have a macro-prudential mandate or macro-prudential instruments.  Its prudential role should be restricted to the supervision and regulation of individual institutions.

The Bank of England should have a macro-prudential mandate (together with the Treasury).  It should also be able to obtain information from and give binding instructions to individual financial entities that it considers material from a macro-prudential perspective.  This means that certain banks and other financial institutions could find themselves reporting to, providing information to and being harassed by both the FSA and the Bank of England.  So be it.  A little bit of redundancy never did much harm.

The decision to put a bank or building society (and ideally any higly leveraged institution deemed systemically significant) into the Special Resolution Regime (SRR) should be taken by the Bank of England.  Under the Banking Act 2009, we have the insane situation that the FSA pulls the trigger (makes the decision as to whether a bank or building society is put into the SRR) but the SRR is managed by the Bank of England.  The Bank rightly objects to this assignment of responsibility without power.  Once in the SRR, a failing institution is under the authority of the Bank of England, except of course when it comes to it being taken into public ownership, wholly or in part. That decision can be taken only by the Treasury.

The anomaly as regards the SRR (the FSA breaks it but the Bank of England owns it) can be remedied without necessarily depriving the FSA of all macro-prudential authority.  This could be achieved by making the decision to put a bank or building society into the SRR a joint decision of the Bank of England and the FSA.  In case of a disagreement, the Treasury would have the casting vote.

(4) Creating new macro-prudential instruments

The white paper is very short on concrete proposals.  Countercyclical capital requirements and liquidity requirements clearly must be part of the new framework.  It would have been helpful to provide some fully worked examples of such countercyclical rules based either on the behaviour or economy-wide aggregates or, as in the proposals of Goodhart and Persaud, on the behaviour of individual balance sheets or other institution-specific variables.  The white paper recognises the desirability of these new instruments being introduced uniformly in as wide a range of countries as possible, to prevent distortions of the competitive playing field.  Agreement at the EU level would be a good practical first step.

Much more could and should have been proposed.  House price booms and busts (and other real estate price booms and busts) are so damaging because of their effects on the construction sector and because so much debt is secured against real estate.  Yet in the space of a single week I read about a 100 percent government-owned bank (Northern Rock) once again giving 100 percent mortgages (mortgages with a 100 percent loan to value ratio), and a building society (Nationwide) giving mortgages with a 125% loan-to-value ratio.  Clearly these institutions are nuts.  They have not learnt  a damn thing from the crisis and what caused it.  Their CEOs should be taken out and shot after a fair trial.

Germany did not have a housing boom.  Hasn’t had one since Varus lost the legions in the Teutoburger Wald.  Why is that? Well, the maximum loan-to-value ratio for residential mortgages in Germany is 60 percent.  It does not take an Einstein to design effective regulation.  Why does the banking regulator in the UK allow these crazy loan-to-value ratios?  Why not take a leaf from the German regulator and limit mortgages to no more than 60 percent of the value of the property?

Both Barclays Cap and Goldman Sachsare proposing new forms of securitisation whose main rationale is to reduce the amount of capital that has to be held against the assets that are being securitised.  Securitisation is, in principle, a jolly good thing, as long as the originator or issuer of the securitised assets is required to hold enough of the equity tranche or first-loss tranche of the securitised assets to ensure a healthy interest in the quality of the underlying assets or in monitoring the relationships underlying the securitised cash flows.  The five percent retention ratio proposed by the EU and endorsed in the white paper is, however, far too low.

Why is it still possible, merely by moving securitised assets off-balance-sheet (traditionally into SIVs, now probably into a vehicle with a less tainted name) to reduce the amount of capital that has to be held against it?  Make capital requirements neutral between institutions holding assets – a bunch of mortgages held by a bank should attract the same capital requirement as that same bunch of mortgages held by an off-balance-sheet special purpose vehicle, unless the funding risk of these mortgages differs materially between the two kinds of institutions.

Crazy remuneration schemes were part of the last credit boom.  They too are back.  A more than 70 percent state-owned bank, RBS, is recruiting talent with a promise of a two-year guaranteed bonus.  Where are the regulators when we need them?  Where are the owners – UKFI, presumable agents for Taxpayers Unlimited, that is, you and I?

All these potentially macro-prudentially destabilising developments are within the law and don’t violate any regulations.  Time to change the law and the regulations.  And put some zip in it, for a change.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website