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.