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You might miss this regulation, but don’t

With so much hullabaloo about banker's bonus taxes, taxes on liabilities, a return to narrow banking, the closure of leveraged prop trading, bankers versus Obama, Sarkozy and Davos, you might miss a few key changes in emphasis.

For example, the bankers view as demonstrated by Bob Diamond's comments yesterday:

'World leaders may find it increasingly
difficult to source finance in the capital markets if they insist on
splitting up banks that are "too big to fail", Barclays president Bob
Diamond has warned.'

Or Lord Adair Turner's, Chairman of the FSA:

'Regulators needed more
than the ability to set interest rates to stop asset price boom-bust cycles.
He urged the creation of a "macro-prudential body" to cut down on lending or
borrowing at times when it thought a bubble was being created.'

But the one I bet you miss completely, unless you're looking, is the speech of the Executive Director for Financial Stability of the Bank of England.

This speech took place in Liverpool last night (20 page pdf).  It's not Davos and he's not Obama, Sarkozy, Brown or even a King or a Darling.  No, he's Haldane.  Andrew Haldane.  And when you've got all attention diverted elsewhere, it's a good time to release news to test the waters of the industry, but not the media who might not appreciate the intent.  So he did, in my humble opinion.

Why is his speech important?

Because he makes it quite clear that the economy has stabilised but the root cause – debt – is still there.  Like the McKinsey report of the other day about deleveraging, he makes it quite clear that we have to deleverage.

What does that mean in reality?

First, that banks should reserve in the good times to over the bad – the procyclicality reserving of profits in other words.  That's nothing new.

Second, the conversion of debt to equity that is state contingent.  Now that one is new.  And by 'state', we don't mean the country as state, but the borrower – whether that borrower be an individual, company or sovereign state.

Here's the section of Andrew's speech that puts this into context:

"Take a typical mortgage contract. A rise in the value of a property relative to the loan gives the borrower equity against which they can borrow. This provides an incentive to tradeup, raising house prices and generating further equity. This amplifier operates symmetrically, as falling collateral values reduce refinancing options and drive down prices. Economists call this effect the financial accelerator. It adds to cyclicality in credit provision and asset prices.

"US economist Robert Shiller has suggested it might be possible to devise mortgage contracts that slow, or even reverse, this financial accelerator. Instead of being fixed in money terms, imagine a mortgage whose value rose with house prices. So the repayment burden would rise automatically with asset prices to slow a credit boom and fall in a recession to reduce the chances of mortgage default. Mortgages would operate like a contractually pre-committed debt-equity swap between households and banks. They would automatically stabilise household loan-to-value ratios. By reducing the amplitude of the credit cycle, they ought to benefit both borrower and lender."

In other words, the idea is that your debt is an 'equity' in the
things you borrow against.  Therefore, if you take a mortgage, you are
not borrowing £100,000 on a £200,000 house, but you are offering a 50%
investment in the house for the bank.  If the house is worth £400,000
five years later, you owe the bank £200,000 or, if it's now £100,000, you only owe £50,000.

Of course, you still have interest payments, but now the asset is shared rather than owned by you once interest and the initial amount borrowed is paid down.

That's quite a big change in how we all think about debt.  It's also
a big investment by banks in our assets, that will now be bank owned
rather than borrowings, especially if this extends to sovereign debt and corporate capital.

In fact, it could fundamentally restructure the way we think about finance.

Bearing in mind how rapidly ideas like procyclicaility reserving and narrow banking have taken off with the regulators in the last year, it wouldn't suprise me if this idea became mainstream in a matter of days or months.

Hmmm … a good day to slip that one under the radar wasn't it?

About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, TheFinanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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