Banks, relax — until the next crisis

Policymakers and regulators say it would be unwise to get too tough with banks at a time when there is still uncertainty about the economic recovery. But studies show such fears are misplaced.

Every economic crisis gives rise to suggestions for radical reform. But these suggestions typically last only as long as the crisis. Once the crisis has blown over, it is business as usual.
    
In 1987, the steep fall in the US stock market prompted calls for rethinking capitalism itself. The US economy quickly shrugged off the stock market fall and the pundits were left looking foolish.

In 1997, the east-Asian crisis evoked several radical proposals — an international bankruptcy mechanism, an overhaul of the IMF, an Asian reserve fund. These too were quickly forgotten once the east-Asian economies began to recover.
    
In 2001, the internet and telecom bubble was followed by demands for rethinking the investment banking model. The storm passed and investment banks carried on with only cosmetic changes in their practices. The one big reform was the passing of the Sarbanes-Oxley Act in the US, which sought to make top management more accountable.
    
Following the sub-prime crisis, there has been an avalanche of proposals for reform of banking. A record number of committees has gone into the causes of the crisis and made proposals. Some three years after the crisis began, it is beginning to look as though it will be a case of a mountain of labour producing a mouse.
    
The sub-prime crisis laid bare the problems in the banking sector. Banks have too little equity and too much debt. In the advanced economies, they rely excessively on short-term funds.

They tend to invest in large amounts of illiquid securities. Bank creditors think governments owe it to them to bail them out when a bank fails. Many banks are so large that they just cannot be allowed to fail.
    
After three years of debate, what do we have? A half-hearted attempt to tackle the first two of the issues listed above. The Bank for International Settlements (BIS) will soon unveil proposals for bank capital as part of what is being called Basel-3 norms. (Global rules for bank capital known as Basel 1 were instituted in 1988.

Basel 2 was introduced in 2007). The indications are that tier one core capital requirements will be pegged at 3% compared to the present requirement of 2%.
    
Banks will have time until 2013 to meet even this modest increase. Most of the bigger US and European banks have tier one core capital of around 10% so they are hardly likely to even notice the new proposals. We still do not know how much the total capital requirement will go up from the current level of 8%.

Nor how much additional capital will be required for banks with a high level of trading activity or banks above a certain size. Banks can relax for now.
    
The world’s policymakers and regulators refute suggestions that intense lobbying by the banking industry is why Basel-3 norms will be pretty mild. They say it would be unwise to get too tough with banks at a time when there is still uncertainty about the world economic recovery. They need to think again. Studies carried out by the BIS show that such fears are misplaced.
    
Getting banks to have more capital has costs as well as benefits. The cost arises when banks pass on the higher cost of equity to borrowers through an increase in lending rates. Higher lending rates mean lower economic growth. The benefit of higher capital is that it reduces the probability of a banking crisis and the consequent loss of output.
    
The BIS has published a paper that captures the long-term net benefit of higher capital. The benefit varies from 1.9% to 5.9% of output depending on whether the permanent effects are moderate or large.

We clearly stand to gain by getting banks to hold more capital. But only up to a point. The benefits of higher capital taper off once the equity to total assets ratio crosses 13%.
    
When the long-term benefits of higher capital are so evident, why are policymakers shy of implementing these? It is argued that there could be problems in the transition. The BIS has another paper that shows these problems at entirely manageable.
    
If the higher capital requirements proposed are phased in over four years, there is a loss of output of just 0.04-0.05 percentage points in the implementation period. Thereafter, output goes back to the original path. These conclusions belie the banking industry’s own studies that showed an impact 10 times as large.
    
Regulators need to take a tough stand on the basis of the BIS studies. The leverage ratio must be pegged higher than the proposed 3%. Total capital must go up to at least 15% with additional buffers for systemically large institutions and institutions with large trading positions. There must not be too many concessions on short-term funding.
    
Would the higher capital and liquidity requirements assumed in the BIS study have kept banks from failing in the recent crisis? The BIS must provide a clear answer to this question.

It was not just lack of capital and reliance on short-term funding that created the recent banking crisis. The third element was mark-tomarket losses on securities. We need norms for securitisation — how much of each category of assets banks can securitise and what quality of securitised assets banks must hold.
    
Higher capital by itself will not lead to stability in banking. Banks will continue to pose headaches as long as we have banks that are so large that they cannot be allowed to fail. None of the solutions proposed — such as getting banks to make ‘living wills’, having ‘contingent capital’ at banks that converts to equity in a crisis — appears convincing.

There is only one fix for this problem and that is to ensure that banks do not get too big for their boots. We must not have banks with assets greater than 5-10% of GDP. This will also make for greater competition in a sector where there is a dangerous level of concentration following the recent crisis.
    
Higher capital will make banks safer but it will also mean lower returns to equity, which means lower rewards for investors and bankers. Limiting the size of banks will mean breaking up some of the large banks.

These reforms are essential but they will not proceed very far because they do not suit banks — and banks have plenty of political clout. Basel 3 is unlikely to resolve the problem of recurring banking crises. We must await an even bigger crisis and Basel 4.