Higher leverage fuelled banking bonanza

Allister Heath
TODAY&rsquo;S banking White Paper will contain some nasty surprises. Of that we can be sure. In the main, however, it will amount to a rehash of pre-announced policies. Some of the proposals will be firm; others more hypothetical, relying on global agreement. There will be a call for banks to structure themselves so that they can easily be wound-down and broken up; there will be requirements for higher capital and much discussion of making this contingent on the state of the economic cycle; and capital will have to be more liquid. There will be lots on corporate governance, the role of non-executives and why bonuses need to be deferred and subject to clawback clauses. The FSA will tell banks on a case-by-case basis how much capital they need; hedge funds will have to provide more information; and so on.<br /><br />Most of those who drafted the White Paper were influenced by a seminal report by Andrew Haldane presented recently in Chicago. Haldane, director for financial stability at the Bank of England, argues that the massive returns enjoyed by banks in recent years (and the vast rewards handed to their staff) were caused almost entirely by higher leverage.<br /><br />To illustrate his thesis, he assumes an investor back in 1900 simultaneously placed a &pound;100 long bet on UK financial equities together with a &pound;100 short bet on general equities. The returns to this strategy &ndash; positive or negative &ndash; would capture the over or under-performance of financial stocks. By 1985, the strategy would have delivered a capital sum of &pound;500, an annual return of just 2 per cent per year. There were periods of both over-performance (1900-1944) and under-performance (1971-1986). All of this changed dramatically during the past 20 years. By the end of 2006, the capital sum would have jumped to over &pound;10,000, an annual return of over 16 per cent. It subsequently all went pear-shaped: as financial stocks collapsed by 80 per cent, the capital sum would have slumped to &pound;2,200 by end-2008, taking the annual return over 110 years back down to under 3 per cent.<br /><br />So what explained this dramatic yo-yoing? A bank&rsquo;s return on equity amounts to its return on assets (which captures a firm&rsquo;s efficiency, the skill of its management and the competitiveness of its industry) multiplied by its leverage. Haldane calculates that since 2000, rising leverage fully accounts for higher returns on equity &ndash; both the surge to 24 per cent in 2007 and the subsequent slump.<br /><br />During the bubble, competition drove down returns on assets and drove up target returns on equity. So higher leverage became some banks&rsquo; only means of keeping up. In future, when gauging banks and their management, we should focus on returns on assets rather than return on equity; doing the former will help us reach the right risk-return trade-off for banks and society. Haldane also points out that nobody knows how much capital institutions should hold.<br /><br />I agree with Haldane until that point. But I would also point out that while there was too much leverage in recent years, much of it off-balance sheet, this doesn&rsquo;t mean all leverage is bad (though everything should be accounted for properly, unlike the scandalous going-ons of the recent past). There was too little leverage in 1986 but too much in 2007. Not all of the rise in banking profits was unsustainable. We might even find out this afternoon whether the Treasury agrees.<br /><br />