This comment by Tim Congdon (International Monetary Research Ltd) on the UK shadow Monetary Policy Committee refers to the “regulatory blight” on banking systems as regulators switch from risk-weighted capital ratio requirements to a straight-forward, unweighted leverage ratio which requires some banks to raise more capital. What he fails to consider is that risk-weighting has contributed to the current parlous state of our banking system. Under risk-weighting, banks concentrated their assets in classes with low risk-weighting, such as residential mortgages and sovereign government bonds, where they were required to hold less capital and could achieve higher leveraged returns. The combined effect of all banks acting in a similar manner achieved a vast concentration of investment exposure in these asset classes, with the undesirable consequence that the underlying risk associated with these asset classes soared, leading to widespread instability across the banking system and fueling both the sub-prime and Euro zone sovereign debt crisis.
My last note for the SMPC opened with the sentence, ‘The regulatory blight on banking systems continues in all the world’s so-called “advanced” economies, which means for these purposes all nations that belong to the Bank for International Settlements.’ As I explained in the next sentence, the growth of banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). The slow growth of bank assets has inevitably meant, on the other side of the balance sheet, slow growth of the bank deposits that constitute most of the quantity of money, broadly-defined. Indeed, there have even been periods of a few quarters in more than one country since 2007 in which the assets of banks, and hence the quantity of money, have contracted.
The equilibrium levels of national income and wealth are functions of the quantity of money. The regulatory blight in banking systems has therefore been the dominant cause of the sluggish growth rates of nominal gross domestic products, across the advanced-country world, that have characterised the Great Recession and the immediately subsequent years. Indeed, the five years to the end of 2012 saw the lowest increases – and in the Japanese and Italian cases actual decreases – in nominal GDP in the G-7 leading industrialised countries for any half-decade since the 1930s.
It is almost beyond imagination that – after the experience of recent years – officialdom should still be experimenting with different approaches to bank regulation and indeed contemplating an intensification of such regulation. Nevertheless, that is what is happening. The source of the trouble seems to be a paper given at the Jackson Hole conference of central bankers, in August 2012, by Andy Haldane, executive director for financial stability at the Bank of England. The paper, called The Dog and the Frisbee, argued that a simple leverage ratio (i.e., the ratio of banks’ assets to capital, without any adjustment for the different risks of different assets) had been a better pointer to bank failure than risk-weighted capital calculations of the kind blessed by the Basle rules. The suggestion is therefore that the Basle methods of calculating capital adequacy should be replaced by, or complemented by, a simple leverage ratio.
For banks that have spent the last five years increasing the ratio of safe assets to total assets, or that have always had a high proportion of safe assets to total assets, the potential introduction of a leverage ratio is infuriating. A number of banks have been told in recent weeks that they must raise yet more capital. Because it is subject to the new leverage ratio, Nationwide Building Society has been deemed to be £2 billion short of capital. That has upset its corporate plans, to say the least of the matter, and put the kibosh on significant expansion of its mortgage assets. And what does one say about George Osborne’s ‘Help to Buy’ scheme, announced with such fanfare in the last Budget and supposed to turbocharge the UK housing finance market?
The leverage ratio has been called Mervyn King’s ‘last hurrah’, since there can be little doubt that King has been the prime mover in the regulatory tightening that has hit British banking since mid-2007. He is soon to be replaced by Mark Carney, who may or may not have a different attitude. Carney has been publicly critical of Haldane and his ‘Dog and Frisbee’ paper, but that does not guarantee an early shift in the official stance. Indeed, it is striking that – of the bank’s top team under King – only Paul Tucker, generally (and correctly) regarded as more bank-friendly than King or Haldane, has announced that he is leaving the Bank once Carney has taken over.
My verdict is that the regulatory blight on UK banking is very much still at work. Further, without QE, the quantity of money would be more or less static. As before, I am in favour of no change in sterling interest rates and the continuation of QE at a sufficiently high level to ensure that broad money growth (on the M4ex measures) runs at an annual rate of between 3% and 5%. My bias – at least for the next three months – is for ‘no change’. It is plausible that I will be advocating higher interest rates in 2014. However, much depends on a realisation in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery. Major changes in personnel may be in prospect at the Bank of England now that Mervyn King is leaving, but the Treasury – which I understand from private information will be glad to see the back of him – has failed to prevent the growth of a regulatory bureaucracy led by King appointees.
If having a well-capitalized banking system requires some “regulatory blight” then lets have more of it. Three cheers for Mervyn King and the (un-weighted) leverage ratio. Let’s hope that Mark Carney follows a similar path.
via David Smith’s EconomicsUK.com: IEA’s shadow MPC votes 5-4 for quarter-point rate hike.
