The speech this week by Britain’s chancellor of the exchequer on the “Reform of Banking” delivered a clear and forceful message: there is still energy and determination to reform the banking system, to make it healthier and safer. The speech is part of a broad agenda of reform in the UK, which has suffered grievously from the financial crisis. This reform agenda has been championed by many. In particular, it has benefited from the wisdom and dogged determination of Sir Mervyn King, Sir John Vickers, Lord Adair Turner and the chancellor himself.
However, I am still left with a sense of unease about the direction that reform of the banking system is currently taking, both in the UK and also internationally.
The chancellor’s speech comprised 3,600 words and contained important and sensible plans for change. But one word was sorely missing. Nowhere, at any point in the speech, was there an appearance of the word “capital”.
The speech, as with much of the current regulatory and reform agenda, focused largely on structures. On the one hand the future structure of banks themselves, and on the other, the structure of the regulatory apparatus that will provide banking oversight. In that context, what received most attention was the chancellor’s proposal to “electrify” the ringfence between retail and investment banks.
There is nothing wrong with an effective ring fence. But as energy and attention is channelled towards such structural issues, it risks being channelled away from the issues of excessive leverage and insufficient capital – the fundamental causes of the crisis. Adequate capital is crucial for building confidence in the banking industry. It is capital that enables banks to absorb the losses that are inevitable as financial cycles run their course. Despite the progress made on capital in the context of the Basel III reforms, the apparent move away from focusing on capital constitutes, I believe, a cause for serious concern.
In the years before the crisis, banks benefited by rapidly expanding their balance sheets and taking on enormous risks. Indeed, from a regulatory perspective they were incentivised to do so. To justify the risk they pointed to demanding targets for return on equity, which in the short term is boosted by high leverage. But return on equity is a deeply flawed measure of the performance of banks, as we discovered when the cycle turned, losses materialised, and society and taxpayers were left to bear the costs. That was, of course, long after bankers had taken much of the rewards of high risk-taking for themselves.
Unfortunately, structural reforms, no matter how thoughtfully designed and carefully implemented, will offer only limited defence for society if banks are allowed to become overly leveraged again. No matter the charge of the electrical current running through a ringfence, banks may still find ways under, around or over it. And even if the ringfence holds, the failure of a large bank, whether purely retail or purely casino, risks having destabilising, systemic effects. The core and unavoidable truth is that if banks are not sufficiently well-capitalised, they will always be vulnerable. And if they are large or interconnected enough, they will be potentially dangerous.
This means that politicians and regulators need, collectively, to have the courage to continue to focus on, and be tough on, the issue of capital. Inevitably, that will be in the face of intense lobbying from those bankers who hope to return to the days of high leverage, high return on equity and high compensation. But politicians and regulators need to maintain a focus on capital, and set simple, clear and transparent rules that force banks to hold enough. Market forces will then take care of much of the rest.
Much of this debate may only seem relevant for some far-off day when economies have healed and bankers’ appetite to take on excessive risk has returned. If only, you might be thinking. But I believe this debate has relevance for today, too. One of the tragedies of the eurozone’s continuing travails is that, more than five years after the beginning of the crisis, there is still a lack of clarity on whether eurozone banks have sufficient capital to make it through the hard days ahead. That restricts banks’ ability to fund themselves in the market. And it stops them from lending enough to encourage and sustain economic recovery. It contrasts sharply with the experience in the US, where credible stress tests for banks, and subsequent recapitalisation where necessary, returned the banking sector towards health. That difference is likely to be one reason why bank lending is now recovering in the US, but stagnating, at best, in the eurozone (see chart).
It is heartening to see that there is continuing appetite and energy for banking reform. But no amount of focus on structures should be allowed to obscure the most important element of that reform. Whatever their structure, we need above all else to ensure that all banks hold sufficient capital. That is the only way to deliver a safe, healthy financial system, capable of delivering the lending that economies need without endangering the public. It is the only way to ensure that, in Mr Osborne’s own words, “when mistakes are made, it’s the banks and not the taxpayer that picks up the bill”.