Bank regulators have got it wrong

I just found a fascinating report released by the Policy
Exchange earlier this year: Capital
Requirements: Gold plate or lead weight?

Policy Exchange is an educational charity targeted to “develop
and promote new policy ideas which deliver better public services, a stronger
society and a more dynamic economy”.

The report takes a big hit at the Bank of England and
Treasury’s approach to the UK Banking Sector and, specifically, the mandate to
increase capital buffers whilst also increasing lending for business.

These two requirements are in obvious conflict, as the
report points out, and demands four key actions.

Here’s a key a part of the Executive Summary:

It is time for the authorities to realise that their desire
to make the banks ever safer is backfiring. The banks are already much safer
than they were in the run up to or during the financial crisis. RBS and
Barclays have reduced their leverage from 27 and 33 times to 15 and 19 times
respectively. Lloyds, Barclays and RBS have all doubled their core tier 1
capital ratios, and under the new Basel 3 (and CRD IV) rules they all have
common equity tier 1 capital of close to 8% compared to the current
requirements of 3.5% for common equity tier 1 and 4.5% for total tier 1 capital.
In short the banks are not only much safer than they used to be, they are also comfortably
above the minima that should now be in place. The Bank of England’s latest
attempts to force the banks to hold more capital are aimed at ensuring they have
a large enough buffer above those minima. That might be sensible at the top of
the cycle but not at a time when the economy is still trying to recover.

Regulators and governments were stung by the crisis and,
understandably, feel that they have to err on the side of caution. Hence we
have Basel 3 that will require the banks to eventually hold 7% equity capital,
compared to 2% previously, and total capital of between 10.5% and 13% compared
to 8% under Basel 2.3 The UK regulatory regime that will require ring-fenced
banks to hold still more capital through an additional equity and other loss
absorbing capital, taking the total Primary Loss Absorbing Capital to 17%, more
than double the requirement under Basel 2. We have new leverage ratios to
constrain the overall size of balance sheets at banks. And finally we have new
liquidity and funding ratios that mean banks have to hold liquidity to meet
their requirements in times of crisis and have much more stable funding. The
regulators have understandably been keen to learn the lessons of the Northern
Rock, HBOS, RBS and Lehmans style failures.

Most of these measures do go in the right direction but the
banks are already well on their way to meeting them. Basel 3 is not meant to be
fully implemented until 2019, but most banks are aiming to be there in the next
couple of years.  The government’s
banking bill has not yet passed into law but Lloyds believes it already has the
17% Primary Loss Absorbing Capital in place. To put that into context, whereas
for every £100 Lloyds used to lend to SMEs under the old regime of Basel 2, it
would have to hold a minimum of £8 of capital, it now has to hold £17 of
capital. No wonder lending to SMEs is falling.

Merely focusing on safety is not enough. We now have to
focus on doing the right thing for the economy more broadly. To achieve this,
the report makes four key recommendations:

Recommendation 1

Regulatory authorities, particularly the Bank of England through
the Financial Policy Committee and Prudential Regulatory Authority, need to
recognise that the drive to higher capital requirements has adverse
consequences. In an ideal world we would like the Bank to abandon its likely
demands for the banks to raise capital. Since we feel the Bank has committed
itself to this course, we recommend that the Bank gives the banks flexibility
over how and when they raise this capital and makes it clear that new capital
raised can and should be used to increase lending. It should also make clear
that any capital raise that is required will, unless there is a dramatic change
in circumstances, be the final one it will ask the banks to make. The Funding
for Lending Scheme stated that net new lending under the scheme would not
require further capital. We would like the Bank of England and FSA to reaffirm
this commitment. Finally we would like the Bank of England to understand that
without credit growth it will not be able to boost demand in the economy and
re-orientate its policy to reflect this.

Recommendation 2

We would like to see much more flexibility in Basel 3 and
its European equivalent CRD IV around capital floors. Under Basel 3 banks are
going to be required breach minimum capital requirements in extremis.
Regulators should not require banks to hold enough capital so that they would
never drop below the capital minima in a stress test, even under extreme
assumptions. This would lead to banks holding too much capital.

Recommendation 3

We believe that the Bank of England and FSA should allow UK
banks to move to Basel 3 liquidity requirements immediately. The current UK
liquidity regime requires banks to hold around 50% more liquidity than Basel 3
in more restrictive instruments. This would free up assets, which the banks
could use for lending instead.

Recommendation 4

The government should oppose any further strengthening of
the ring-fence around the UK banks. The UK now looks set to be the only major
economic centre that will be imposing a ring-fence on its banks. The EU
Commission has recognised the downside in terms of the impact on growth, with
European Commissioner Michel Barnier saying “I don’t want to penalise the work
of banks when they work for the benefit of the economy and industry”. He also
said he was keen “to move on as soon as possible from the agenda of reactive
repair to a proactive agenda”. The comments of the Parliamentary Commission on
Banking Reform on the ring-fence and other issues show that too many in the UK
are still in “reactive repair” mode. We believe the ring-fence is the wrong
answer to the wrong question. Retail banks are safer than investment banks as Northern
Rock, Bradford & Bingley and HBOS proved. So we would argue that the
regulators focus on protecting the whole bank and one way to do that is to
ensure it remains competitive with its global counterparts. The ring-fence far
from being electrified should be made as flexible as it needs to be for the
competitiveness.

You can download the report here.