A leading economist’s view on how to manage financial regulation for the long term

ALL financial regulation is inherently procyclical. After a crisis has occurred, the immediate, inherent response is “that must never be allowed to happen again”. Thus after the South Sea Bubble, limited liability, joint stock incorporation was effectively forbidden. The problem is that regulations prevent agents doing what they want to do, and hence limit innovation and growth. As time passes, and no further crisis ensues, the drawbacks of such restrictions come to appear more damaging and unnecessary than the benefits. Also there is often a national race to the bottom: buzzwords such as “light touch” or “we can move to a nicer country” and so forth ensure regulation erodes over time. The next major crisis can be plausibly dated as occurring in 20 years time.

Also market forces make regulation procyclical. Market values, profits, capital and ease of market access to liquidity and funding more generally are all easier to achieve in a boom. So a given capital/liquidity ratio can also be more easily achieved then. Current developments, especially in Europe, represent an extreme example. Regulatory equity requirements have gone from around 2 per cent or less of risk-weighted assets in 2007 to 9 per cent by June 2012. Liquidity requirements, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), are following along, though fortunately with long lead times and long lags before full introduction. Even so, the imposition of toughened regulatory measures is one of the more important factors behind the current massive deleveraging in European banks. Many of the main banks, such as RBS, are cutting their balance sheets now almost as aggressively as they expanded them before 2008; and both tendencies will have aggravated the cycle.

Does it matter? If you are a monetarist, it certainly does. Less so if one focuses on bank credit, because a shift from deposits to capital should have relatively little effect, even perhaps positive – for example, reducing zombie loans and increasing loans for new, better enterprises. Nevertheless it is hardly to be recommended.

So, how do we deal with such procyclicality? First we must recognise the syndrome. There is an attempt by the Basel Committee in Banking Supervision (BCBS) to use capital adequacy requirements in a counter-cyclical manner, with a 2.5 per cent add-on. There are, however, justifiable doubts whether it will work. First, 2.5 per cent is just too small: compare financial conditions in 2006 and 2012. Second, it will be difficult and unpopular to claim that an increase in prices and market values is unsustainable; so there is a need for “presumptive indicators”, but there is considerable disagreement on which to use. Third, uncertainty about the transmission mechanism will make for caution, at least for a time.

What else can be done? The application of ratio control was not based on any proper economic analysis. It was purely pragmatic in 1987/88. Basel I and II requirements actually worsened the use of equity as a buffer against unexpected losses for a going concern. Bank managers focus on return on equity, because they answer to shareholders. Capital adequacy requirements (CAR) make achievement of a high return on equity more difficult. Bank managers therefore responded by lowering the quality of CAR capital, increasing leverage relative to risk-weighted assets and reducing the buffer above the minimum required CAR.

We need a new approach to ratio controls. Instead of one ratio, two. A much lower ratio where a bank becomes too dangerous to allow management to continue, and a much higher, fully satisfactory level. The two need to be connected by a ladder of sanctions, mild to begin with, more severe as we move towards closure point. Sanctions could be charges for milder shortfalls, with limits on out-payments, dividends, buy-backs and bonuses for more serious shortfalls. There is a precedent in the BCBS conservation range for a higher ratio of 7 per cent and a floor ratio of 4.5 per cent.

Equity shareholders, with limited liability, share the same incentives to take on extra risk as the managers have, with a limited downside and unlimited upside potential. As the market value of equity falls, more of the potential (tail) risk of absorbing losses falls onto bond-holders and/or taxpayers. The need then is to find a way to transfer governance and control to such other risk-bearers increasingly as equity values fall. The call for Co-Cos and bail-in-able bonds goes some way in this direction, but there can be contagion problems. There should be a much greater willingness to embrace taking weak financial intermediaries into temporary public ownership, if and when necessary, before they have completely crashed into the rocks of bankruptcy.

Charles Goodhart is emeritus professor at the London School of Economics and a former member of the Monetary Policy Committee. He will be delivering today’s keynote speech at Gresham College’s Long Finance event, Into the Folly of Value, at Bank of America Merrill Lynch. www.gresham.ac.uk

“The next major crisis can be plausibly dated as occurring in 20 years time.”