Introduction
It is helpful at this point to consider the big picture, the underlying political economy of bank capital. In a laissez faire world with no central bank and no financial regulation, banks would sink or swim with no expectation of being bailed out by the state or its agencies if they get themselves into difficulties.
Enter central banks and regulators, who set up lender of last resort facilities, deposit insurance and such like, and associated expectations of bailout. The bankers respond to these incentives by increasing their leverage and taking more risks to boost their returns on equity, which are the basis of bank CEOs’ remuneration. High leverage seeks to maximise the value of the (often implicit) central bank or government guarantees by letting banks borrow at rates subsidised by society at large, thereby privatising profits on the upside and socialising losses on the downside. The bankers’ social contract is not a good one for everyone else, however. The central bank huffs and puffs that banks should not take excessive risks and threaten to let them fail, but the bankers see through these empty threats and call their bluff, knowing that in a crisis, central bankers will bail them out for fear that not doing so might collapse the financial system. Round One to the bankers.
The Central Bankers
Basel II is then rolled out to great fanfare, the GFC hits shortly afterwards and it became clear (admittedly, earlier to some than to others) that Basel II had allowed banks to be woefully under-capitalised.
Problems of Basel II
The banks promoting higher leverage means the banks promoting excessive leverage, and excessive leverage periodically crashes the financial system, leading to one disaster after another and repeated taxpayer bailouts, each bigger than the last, until eventually the public refuse to put up with it any longer.
The remuneration received by the bankers for taking the excessive risks that led to the crisis was but a small fraction of the banks’ subsequent losses which was in turn but a small fraction of the damage inflicted on the economy.[1] So huge damage is being inflicted on the economy so that bankers can extract relatively small rents from it. The bankers have become the new unions.
It is, accordingly, imperative for those with the public interest at heart to appreciate the game that the banking lobby has been playing so successfully against the public, who are repeatedly called on to bail the bankers out.
If the bankers were to pursue their socially destructive high leverage agenda out in the open, where everyone could see it for what it is – that the bankers make a lot of profits for themselves in the good times, and the public bail them out in the bad – then it would be harder for them to get away with it: there would be a public outcry and politicians would be under enormous pressure to put a stop to it. The bankers therefore need some cover story to give them a fig leaf of respectability, the objective being to make high leverage seem reasonable, and even desirable.
This is where the ‘hold capital’ fallacy – the claim that banks ‘hold’ capital – comes in. This fallacy feeds into the widespread misperception, promoted both by the banking industry and by the BoE, that high capital requirements are somehow a constraint on bank lending. “Of course we know that excessive debt is a bad thing,” they say, as if excessive leverage was anything but that, “but if we have to hold more capital, then lending and unemployment will be badly affected, and no one wants that.”
The bankers’ pitch sounds right, but it isn’t
To quote Admati:
If capital is falsely thought of as idle cash, the discussion of capital regulation is immediately derailed by imaginary trade-offs. Nonsensical claims that increased capital requirements prevent banks from making loans and ‘keep billions out of the economy’ may resonate with media, politicians and the public just because the jargon is misunderstood. In light of this confusion and its ability to muddle the debate, it is disturbing that regulators and academics, who should know better, routinely collaborate with the industry to obscure the issues by using the misleading language and failing to challenge false statements. If, instead, the language that is used focused attention properly on funding and indebtedness, the debate would be elevated and more people would be able to understand the issues. (Admati, 2016).
And again:
This is not a silly quibble about words. The language confusion creates mental confusion about what capital does and does not do. This confusion helps bankers, because it creates the false impression that [more] capital is costly and that bankers should strive to have as little of it as regulators will allow.
For society, there are in fact significant benefits and essentially no cost from much higher capital requirements (Admati & Hellwig, 2013, p.98).
It is, then, unhelpful when the regulator, who should be holding the fort on the public’s behalf, buys into the industry PR campaign with statements like this one:
The FPC was concerned that banks could respond to these developments by hoarding capital and restricting lending. (Carney, 2016, our emphasis).
When the regulator itself promotes industry PR instead of debunking it, then we should not expect the regulator to be effective. In truth, the regulator has long since been captured by the industry and the regulator’s dismal performance, while shocking, is only to be expected. The bank capital regulatory system is broken and it will take a lot more than any Basels IV, V or VI to put it right. At some point, there will need to be radical reform to reverse the ever more destructive banksterisation of the economy and re-establish a Social Contract in which the bankers serve the public and not the other way round.
Note
[1] Consider the following. (a) We can estimate this remuneration as the size of the subsidy that banks receive by virtue of taxpayers being expected to bail them out when their risk-taking goes wrong. To estimate this subsidy, Haldane (2011) outlines an approach that estimates the value to banks of the difference between typical credit agency ratings, the first of which takes into account likely government support, and the second of which does not. Based on this (admittedly rough) methodology, he estimates the annual risk-taking subsidy to UK banks to be about £59 billion over 2007-2009, and to be almost twice that for 2009 alone. So the subsidy is roughly on a par with their reported annual profits. (b) Bank losses from the GFC were at least £500 billion. (c) Haldane (2011, p. 4) reports GFC-related output losses for the UK of between £1.4 trillion and £7.4 trillion. The first and third of these estimates should be regarded as very rough, but it is reasonable to consider them as giving respective orders of magnitude. See A.G. Haldane, “The $100 billion dollar question,” speech given to the Institute of Regulation & Risk, Hong Kong, March 30th 2010.
References
Admati, A. (2016). The missed opportunity and challenge of capital regulation, National Institute Economic Review, 235, R4-R14. doi. 10.1177/002795011623500110
Admati, A., & Hellwig, M. (2013). The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About it, Princeton University Press. [Retrieved from].
Carney, M. (2016). Redeeming an unforgiving world, February 26th. [Retrieved from].
Haldane, A.G. (2011). Capital discipline, Speech given at the American Economic Association, Denver January 9th. Chart 8. [Retrieved from].
Haldane, A.G. (2011). Control rights (and wrongs), Wincott Annual Memorial Lecture, Westminster, London, October 24th. [Retrieved from].
Haldane, A.G., & Madouros, V. (2012). The dog and the frisbee, Speech to the Federal Reserve Bank of Kansas City’s 36th economic policy symposium, “The Changing Policy Landscape”, Jackson Hole, Wyoming, August 31st. [Retrieved from].