Friday’s first report of the Financial Policy Committee of the Bank of England was an important event. This is the new body charged with regulating the banks and main financial institutions. To the tabloids, it is the Bank’s committee to prevent another Credit Crunch. It will absorb and take over many of the duties of the Financial Services Authority and the Bank’s remit to manage systemic risk.
As you would expect the Committee produced a heavyweight document. It had plenty of analysis and factual information. It correctly identified sovereign debt risk as the biggest immediate threat to the whole system of global banks. It pulled no punches about the severity of the Euro crisis.
The worry I had reading it was a simple one. Did these clever and well informed people make a sensible judgement about what they should do – if anything – to manage the risks they rightly perceived? A systemic regulator has to go beyond coming to well informed academic conclusions about the state of the world to deciding if it can and should make an intervention which will reduce the risks being run in a helpful way.
Their prime recommendation to tackle the sovereign debt dangers was to “advise the FSA to ensure improved disclosure of sovereign and banking sector exposures by major UK banks…” I support more disclosure of these positions. Better knowledge allows the market to make more sensible judgements about risks in banks. It also might make bank executives more worried about owning too many government bonds which could go wrong.
However, it does not help solve the sovereign debt problem. Nor does it help the banks in the short term. It will enable market participants to apply discounts to the holdings of government debt by banks to reflect risk of default in the worst cases, and risk of loss owing to rising interest rates in all cases. Meanwhile the regulators continue to score government debt in each country of issue as risk free. The Regulators need to ask themselves tougher questions about how in the medium term they will reflect in their calculations the interest rate risk and credit risk in sovereign bonds. A sharp move to too much caution now would not be helpful, but the longer term position is not sustainable, as these bonds in some cases have been imprudently evaluated and counted.
The second main recommendation of the FPC sees them wrestling with the central conundrum for the UK economy. Is the priority to build up more and more bank capital to prevent another 2008-9, or is it to secure more bank lending to allow faster economic growth?
They say “The Committee advises UK banks that, during the transition to the new Basel III capital requirements, they should take the opportunity of periods of strong earnings to build capital so that credit availability is not constrained in periods of stress.”
This goes to the heart of the current dilemma. The government and public want a more vigorous recovery. That requires more bank credit to pay for more private sector demand and more business expansion. The Regulators want to buttress cash and capital at banks to much higher levels, so they can relax about the impact of any future crisis on banks. You cannot easily do both at the same time.
The crucial advice to banks is unclear. Is now a time of “strong earnings” so they should be putting away more profit for a rainy day? How can you make more money available at times of stress, if a time of stress is defined as a time when little money is available? Isn’ t the danger of all this that the regulators are in effect encouraging the banks to be super prudent at a time of little growth?
The FPC needs to discuss the idea of counter cyclical regulation. Many now genuflect to this idea. It states simply that when economies are running hot and banks are expanding rapidly, the regulators should lean to demanding banks hold more cash and capital to cool things down a bit. When economies are running slowly and banks are not expanding their balance sheets much, the Regulator should relax the advice on cash and capital sensibly, whislt keeping acceptable minimum standards. China, for the last year, has been calling for much higher special deposits, raising interest rates and taking other monetary action to slow her economy because of the inflation and fast growth. She did the opposite in 2008-9 to offset the deflationary effects of the western Credit Crunch.
The FPC needs to have a view of the cycle, and to express this in its cash and capital advice. Of course there should always be acceptable minimum levels. All the main UK banks are well above those today, following a huge squeeze on the RBS balance sheet and appropriate action elsewhere.
I would have liked the FPC to say this:
“The UK economy, in common with several other western economies, is operating below the peak levels of 2007-8, and has been growing slowly since the recession bottom. We judge the current need is to accelerate the growth rate somewhat. We regard an 8% Tier One Capital Ratio as the necessary minimum (compared to 5% hit by some in 2008). We advise banks to exapnd their balance sheets sensibly, offering more Uk lending. We will only be requesting higher levels of cash and capital in the event of sustained resumption of growth above trend for more than a year”