Banks – Crash, bash and cash

The battle of Basel continues. At the G20 leaders will briefly consider some of the complex issues over how banks will be regulated after the Crash. Later in July there will another important meeting to seek global agreement on how to control banks and to avoid another banking disaster.

Basel I in the 1990s said that banks had to keep Tier One Capital – the money their shareholders had put up and their retained profits – at 4% of their “risk assets”, and to keep their wider capital at 8%. “Risk assets” meant all the loans and financial instruments they owned. These were weighted according to how risky they were thought to be. If a bank lent to an OECD government they did not have to include that in their loan total at all. If they lent to a private sector company they had to include all that loan in their total.

Basel II revised Basel I. They still required 8% capital, split 4% and 4%. For some banks, like Northern Rock, they ended up with more capital and less risky asset from the changes to the definitions and the way they did the sums. This came into effect in 2006, and helped stoke up the credit boom further, allowing some banks to lend even more near the top of the cycle. The Regulators meeting to agree Basel II wrongly thought the financial world had got better at managing risk and this could be reflected in a more lenient view of how to calculate assets and capital.

Basel III may come out near the bottom of this cycle unless it is further delayed. Many elements of it are still up in the air, but the likely outcome is to demand more cash and capital from banks than the previous regime, and in some cases more than they currently have. One analysis suggests that if they agree the proposed “Net stable funding ratio” banks may only have 85% of the capital they need to comply. There are many arguments still going on. Should deferred tax, software and intangible be included in Tier One capital? Should the Tier One capital ratio be raised from 4% to 6-8%? How can different parts of the world be made to value and report assets on the same basis? What are the appropriate risk weights that apply to each type of loan or asset a bank owns?

The politics are simple. Banks are generally unpopular – in many cases and countries even more unpopular than governments and politicians. As the cycle begins to improve, banks start to make much more money. Governments seek popular approval by taxing the banks more, in order to tax people directly less. This cuts banks capital from profits and means they have less money to lend. It also encourages banks to charge more, making them even more unpopular.

Governments are terrified there will be another banking disaster. They want people to believe the banks were solely to blame, that 2008-9 had nothing to do with weak or poor regulation. They may even believe this themselves. There is the constant sound of governments slamming doors long after the troubles have left. There is a penchant to impose much stricter controls on cash and capital than before. If they had imposed such controls in good time on the way up – in 2005-6 say – we would have avoided the worst of the Crash. Imposing such controls now will delay or damage recovery, as it too will mean less bank lending.

The governments think they face a dilemma. Surely, they reason , we need to be tough on the banks for political reasons, and to prevent any chance of recurrence of trouble? Isn’t it a win win to make banks hold more cash and capital? But they also want those same banks to lend more to private sector companies to expand and create jobs. Those loans to private companies have always scored fully as risks for the banks, and will continue to do so. That means banks under a new tougher regime will lend less, at the very time governments are telling them to lend more.

Governments need to be brave rather than political. They need to say we have to allow the banks to lend more and make more profit, as we need them to finance the recovery.The best way to strengthen the banks is to allow an upswing, and then demand more cash and capital once the upturn is well established. Governments will also get more tax out of them if the economies the banks support start to grow more quickly. Some discussing Basel III say they want to be counter cyclical for a change. That means delaying demands for more cash and capital for a bit. The banks on the whole are much stronger than they were in 2008.

The best thing the governments can do to help is to make sure no government goes bust or rats on its debts. Having allowed or required banks to lend trillions to governments on the basis that this was risk free, it would be very damaging if it turns out to have been very risky.


  1. Tapestry
    June 27, 2010

    Sovereign default might be a cheaper option. If Greece can withdraw from the eurozone, for example, and partly default on her euro-denominated debts, by linking them to the new drachma, this could well save the creditor nations and banks yet bigger losses down the track. Default is a way out of mess already created. Losses are usually best taken early, so new growth can accelerate.

  2. waramess
    June 27, 2010

    Oh what a mess. Basel1 and Basel 2 both contributed to the crash by focusing banks attention on circumventing the capital adequacy rules, hence the imperative to have an AAA rating applied to many junk bond offerings. Basel 3 will be no different and until something is done, Governments will still be the saviours of insolvent banks.

    The measure of how much borrowing should be made available to banks against capital was once a free market function made by lenders to the bank but even this was imperfect because bank creditors still had Governments as the backstop.

    Forget Basel 3 and concentrate on a viable means of liquidating failed banks and we might start getting somewhere.

  3. Lindsay McDougall
    June 27, 2010

    Three questions for governments:
    (1) If you don't know how to regulate, why regulate at all? Just say to any bank that holds out its begging bowl.
    (2) Is it necessary that all national governments regulate identically?
    (3) If it is not necessary, why hold a WASTEFUL international conference?

    1. Mark
      June 27, 2010

      It's clear that different countries face banking problems with different origins. Germany's banks have no problems with domestic mortgage lending – neither do Greece's or Italy's. That is a core problem for the UK (particularly as we have continued to prop up house prices, delaying and increasing the problem rather than facing it), Ireland, and Portugal and parts of Spain. UK banks have limited exposure to PIGS (Ireland is important but not life-threatening). German and French banks are major holders of government debt of PIGS. The major portion of UK overseas borrowing is funding our mortgages: gilts are mostly funded domestically by ramming them down the throats of pension funds or QE.

      1. DBC Reed
        June 28, 2010

        Finger on the problem right here.There is no point in calling for increases in bank lending if most of the new credit goes into the property market ,as it does in the U.K..The new Financial Policy Committee may stem the flow of cheap money in this direction,but what is a Conservative / Orange Book government doing agreeing to the State direction of finance by committee.?
        A tax on property would have the same effect leaving matters to the decentralised decisions of the people as captains of their own economic fates.As everybody knows if you have to tax property,its best to levy the underlying land values which prevents land hoarding and builds massive infrastructure projects for free.

  4. Acorn
    June 27, 2010

    I have been trying to learn, as part of my teach-yourself-macroeconomics plan, how QE is supposed to affect money supply. The following from the BoE was useful. It is worth a read.

    I also found an old BoE document that says the IMF considers Local Government and government owned corporations as part of the private sector. Now there IS a good idea Mr Pickles. In fact, I can think of 433 local government examples, where it would be a very good idea.

    1. APL
      June 27, 2010

      Acorn: " .. QE is supposed to affect money supply."

      Do remember a couple of things. Many banks are insolvent and should have been closed down.

      They are insolvent largely because they made investments the success of which were predicated on an ever growing economy and GDP. In other situations this requirement to pull in more gullible clients might be called a ponzi scheme.

      At any rate, in an expanding economy QE might not altogether be noticed, because people generally feel more prosperous. In that scenario, it is called inflation – the government has practiced 'controlled' inflation since the end of the first world war.

      The thing about QE now is that it is being used to prop up an economy that effectively no longer exists. Western Governments are in a terrible bind, they can no longer afford to borrow on the scale that is necessary to continue QE at the rate they have been up until now.

      But the can't pull back too fast, because there will be a smoking hole where the economy was. It is there now, it's just not visible. This is the economic equivalent of the 'phony war'.

      QE cannot do any good in a contracting economy, deflation is bigger and stronger than any government printing.

      we are on the verge of a 'kondratieff winter'.

  5. Norman
    June 27, 2010

    What we need is less regulation, not more.

    Here's the questions I would like answered.

    Why was the Community Redevelopment Act necessary and why was it expanded by successive American governments with the threat of red-lining any banks who didn't comply with giving loans to people who couldn't afford them?

    Why were these given AAA ratings? I suspect that it was more a political decision as to do otherwise would be to tacitly condemn the politics behind this.

    How can we stop ideological politicians from imposing their will on the private sector in the future?

    Banks are there to make money, the banking sector aren't going to play 'casino banking' with their savers money – it's ridiculous that politicians continually push this meme to distract attention from themselves. I'm getting fed up of all this bank bashing. How much capital they hold, etc. means nothing if the loans banks grant aren't sound – leave these decisions in the hands of experts, not quangos and politicians.

  6. Mike Stallard
    June 27, 2010

    Every now and then, the dear old Catholic Church is spot on. Iraq? Remember? Communism? Remember?
    Now, in banking, Vincent Nichols has said something. As far as I can understand it it is this:
    If Mr X walks into a bank and manager is honest, then a deal can be struck. If the manager is bent or greedy, or mean, than the deal won't help Mr X.
    Similarly, if a "banker" is sitting looking at totally meaningless names on a screen and playing with figures, how can he know which is a good bet and which is a bad one? Or care? Without honesty, there can be no meaningful banking. It is just guesswork, like Deal or no Deal.
    Now add in the dear old clumsy, international government figures who have no clue about banking (because it is political and needs votes not notes) and you are going to get a lot of guesswork, a lot of "experts" from academia and the media (who have quite often not invested their own money) and they are going to get it roughly right. In a way that is.
    At the moment, we are running blind and that is very dangerous – and very rewarding for just the lucky or the wrong kind of person. Meanwhile, guess who cops it?

  7. FatBigot
    June 28, 2010

    Any number of international agreement cannot escape the fact, for fact it is, that the more local the oversight the more effective it will be. Even nationwide identical rules for capitalisation of banks force some to hold more Tier 1 Capital than their business requires to be stable and others to hold too little.

    The only effective regulation against bundles of potentially dodgy home loans was that effected in Canada and Australia where the banks were not allowed to invest in anything they could not value (to put the position in a grossly simplified nutshell). That didn't require international jamborees, it only required the application of a bit of pretty obvious common sense.

  8. christina sarginson
    June 28, 2010

    It is clear that many of the different countries do have different regulations and therefore the need to make these work is different. The goverment's job is a hard one to allow free enterprise but to enable the banks to be stable with other people's money. The issue now is that most people do not trust the banks as they have played the markets and lost and the tax payer has picked up the pieces of this so I will wathc with interest and see what the outcome is.

  9. Javelin
    June 28, 2010

    What worries me about the current crisis is not banks lending to unsuitable borrowers but Governments borrowing from unsuitable lenders.

    If the West become indebited to China – for lets say 20 trilion (the UK 1.5 trillion) then China can raise interest rates in the West by holding back relatively smaller amounts from lending in the bond markets. So with an issue of 100 billion bonds by a Western Government China could push interest rates up by a full percent – over 5-10 years.

    Sovereign funds in the middle east have already stated they are going to stop buying Western bonds.

    Because China also has control of FX rates they can also squeeze more yuan for the buck by lowering exchange rates.

    The assumption that China will not want to hurt itself by squeezing Western Governments too hard basically defies the reality of loan sharks. Loan sharks do exist and stay in business by squeezing the customer and keeping the customer in debt. If China can squeeze the Western Governments by raising interest rates BUT keep growth in Western countries low enough to not allow them to shake off the debt then they will be acting like loan sharks. I can see it as a possiblity.

  10. Adrian Peirson
    June 29, 2010

    We shouldn't be borrowing money from international loansharks, we as a Sovereign nation ought to be responsibly coining our own.
    In addition, I havent heard a word about getting major Industries back on line, industries like car manufacturing, ship building, steel manufacturing, repatriating our fishing, it was only recently our harbours were full of fishing vessels.
    An imported car in this country costs £6k, is Westminster trying to tell me we can't make cars for £6k in this country.
    We would also have something to sell abroad, if we had retained these industries, would we be in this mess.
    In addition, I'd have let the banks fail, and written off everyone's mortgage debts, business loans, credit card agreements to those banks.
    People would have more disposable income, they would have spent, so stimulating the economy.
    Come on Generals, kick Komrad Kameron out of no 10 and put me in charge, I promise I won't grow a moustache, and I'll throw in a couple of Aircraft carriers, 3 subs, 100 tanks and some more aircraft, let's say another 100.

    These industtries still exist, how much would it cost to inject some capital into them, £2 Billion, even £5 billion is peanuts to the amount we have given the Banks, and have the banks turned round and said they are going to invest in British industry and people, no, they are holding onto the bailout money and are going to allow the system to crash then buy up Britain for pennies.

  11. Anon
    July 2, 2010

    "Isn’t it a win win to make banks hold more cash and capital?"

    "But they also want those same banks to lend more to private sector companies to expand and create jobs."
    Is that what ALL businesses want? If money can be made then an entrepeneur can find the money, by hook or by crook.

    "The best way to strengthen the banks is to allow an upswing, and then demand more cash and capital once the upturn is well established. "
    What's the definition of "well established"? At that point in time, won't everyone just go back to BBA and forget the need for holding more cash? It's easy to forget the pain when it's a distant memory.

    Banking is Licensed. It could be argued that it should be regulated & supervised, because the act of licensing it distorts the free market it operates in.
    If instead of 4-6 superbanks in the UK we had 4000-6000 with less regulation then would be in this position Today?

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