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Tony's Ten: Banking crisis - more regulation than conspiracy

21 August, 2012Tony Gandy

Yet again it has been a few weeks of individual chaos for banks all adding to a continuation of the industry’s poor image, even if the accusations were not quite what were presented. HSBC were fined for poor anti-money laundering controls and Standard Chartered’s embarrassing run in with a new gung-ho regulator in New York and various other hiccups along the way meant that the two banks arguably least affected by the industry malaise were both chastised.

Of more importance than the fines is that banks are not lending. In a rather odd moment it was reported (Reuters 2/8/2012) that the UK government was considering nationalising the part of Royal Bank of Scotland it did not own because of its frustrations with the banking sector not doing what various politicians are imploring them to do – lend more. This seems somewhat at odds with previous speculation that the government would wish to raise some much-needed cash at some stage by selling parts of its stakes in the banks it bailed out.

However, why would full nationalisation make sense – the banks are not refraining from lending out of spite. In a recent report from Morgan Stanley (Regulatory Policy Activism – But How Much Traction? 9/8/12 – written by their top bank equity analyst Huw Van Steenis), it is argued that regulation is the cause of a massive fall in lending and therefore money supply. The only way nationalising RBS would help would be if government then suspended the bank’s need to comply with new regulatory requirements which would clearly be anti-competitive.

According to Morgan Stanley, Basel III (the new global capital adequacy, liquidity and leverage regime) is a key underlying issue coupled to a new emphasis put on bank prudence by financial markets.
On 1 January 2015 (d-day), banks will have to have complied with new Basel liquidity rules. These require banks to hold a much greater proposition of liquid or near liquid assets – this is the key reason that banks have increased their deposits at central banks. Morgan Stanley note that while European banks have grown liquid assets to €2.8tn, they need to build up another €1.15tn by d-day – this is cash they will not lend and is effectively taken out of the system.

Nevertheless, compliance with liquidity rules is still only a part of the problem. The real challenge is to comply with regulatory and market expectations that the ratio of loss absorbing capital to assets which banks have increases – and increases a lot. Here is a really big issue. When a bank lends to government, by say buying a gilt, the asset created in the banks books is given a 0% risk weighting – meaning they need to hold capital against lending to governments – even though we know such lending is much riskier than it was a few years ago. Some forms of alternative assets have a remarkable weighting of 1250% meaning 1) no bank worrying about building up their capital ratio could possibly hold those assets and 2) banks will have to make a remarkable profit on such an instrument if they are to possibly make an adequate return on capital. Thus banks buy gilts and do not lend to the real economy. This is great for governments wishing to borrow, but between the liquidity and capital requirements, it means banks are not interested in lending to the productive economy – and this is not out of choice, this is what the rules demand.

Even the head of the ECB, Mario Draghi, seems to have acknowledged the issue stating in a recent speech in London (Global Investment Conference 26 July 2012) that liquidity regulations need to be “recalibrated”. Quite what he meant I am not too sure, but then there was much in the speech that raised more questions than answers. Some examples:

  • “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years”… “Now something must have changed in the air…The bumblebee would have to graduate to a real bee. And that’s what it’s doing.” …“structural reforms will actually graduate the bumblebee into a real bee”
    Hmm, he probably did not read biology as a degree. But then we also have:
  • “as far as inflation, employment, productivity, the euro area has done either like or better than US or Japan… the euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits”
    So far so good, then:
  • “it also has a degree of social cohesion that you wouldn’t find either in the other two countries”
    This must come as news to the Japanese.
    I think the stress is showing in Frankfurt.

Dr Tony Gandy, Reader, Postgraduate Programmes