Leverage is all the rage: The crucial future task for central banks

 
Charles Haswell
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In a post-crisis economy, it’s an elected government that should determine how much leverage there should be across the whole financial system (Source: Getty)

People who believe that banks just move other people’s money around, and those who draw comfort from high savings levels, will tell you that bank lending is not critical to economic growth. And they’ll argue the issue is demand, not supply.

This is a very old argument. You’ll find it in the remarkable Report of the Committee on Finance and Industry. After the stock market crash of 1929, the British government realised that it did not understand how the economy, and money, worked. It asked Scottish lawyer Hugh Macmillan to head the Committee “to inquire into banking, finance and credit, paying regard to the factors both internal and international which govern their operation, and to make recommendations calculated to enable these agencies to promote the development of trade and commerce and the employment of labour”.

It’s a pity we didn’t ask the same question in 2008. Instead, we looked at one of the symptoms of the crisis – the sudden consumption of bank capital by assets that had ceased to perform – and assumed that the long term solution lay in very much higher steady state ratios of capital.

If you didn’t know that banks create money, instead of just moving it around; and if you calibrate economic impact by assessing how banks price their assets, rather than looking at the volume they have the capacity to create, then high capital ratios are a pretty much cost-free solution. Swapping equity for a lot of the debt on the liability side of the balance sheet shouldn’t add much to the cost of the liability stack. So there’s little need to reprice the asset side, which should mean little economic impact.

High capital reduces regulators’ worry about the quality of bank assets. And they can reduce their worry further still by making debt loss-absorbing, as well as equity (even if some investors prefer debt not to be a gamble). All fine, as long as you don’t recognise that high capital ratio requirements kill capacity for volume.

This brings us back to the problem of state planning: the aversion to interfering with banks’ processes for acquiring assets. We prefer to watch the plane crash and ensure in advance that we have enough coffins, rather than try to stop the crash in the first place.

But in a financial crisis, assets don’t really die. Their value just goes away for a bit because nobody knows what anything is worth, and no-one wants to buy anything.

It’s generally not real value that disappears, it’s liquidity. The fact that regulation requires you to mark the value of assets to the market, when there isn’t one, precipitates fire sales. Walter Bagehot first set out what central banks need to do at such times, embellished since by Mark Carney on 24 October 2013 and Mervyn King’s concept of the Pawnbroker of Last Resort, which notes that it’s useful to have a reference price for all assets before a crisis.

That reference price is useful for another reason – the likely haircut helps you know the long-term riskiness of the asset (different from short-term riskiness in a crisis). True long-term riskiness is a better indicator of the appropriate ratio of capital you should hold against an asset.

The relationship of your capital to your assets is expressed in leverage. Credit growth requires leverage – without it, a financial system is not a financial system; too much of it, and the financial system is precarious.

In a post-crisis economy, it’s an elected government that should determine how much leverage there should be across the whole financial system, just as government determines how much inflation there should be. A central bank’s job should be to keep leverage, and inflation, to their respective government-set targets. An inflation target helps you to regulate the price of bank credit. A leverage target helps you to regulate the volume. If you adjust system leverage by adding or subtracting capital ratio requirements solely on the basis of the riskiness of asset classes, you avoid the state planning problem. And if you regulate both dimensions of money – price and volume – you avoid problems that can arise when you turn a measure into a target.

Which brings us back to a simple Macmillan Committee prescription: “The role of a central bank should be to regulate the volume and price of bank credit”. Still good, after all these years – only maybe until now we just hadn’t worked out how to do it.

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