THE government has announced it will implement the recommendations of the Independent Commission on Banking (ICB). The two headline proposals are to “ring fence” the retail banking parts of universal banks from their supposedly riskier investment banking parts, and to roughly double banks’ regulatory minimum equity ratios.
Many bankers are complaining. They claim the ICB has gone too far, that the proposed new minimum equity ratios are unnecessarily high. Who is right? Are the current equity ratios really half what they should be? Or, more generally, just how much equity should a bank hold as a portion of its assets?
In principle, the question is easily answered. Because dividends are paid from post-tax profits but interest is a pre-tax expense, a company can reduce its overall cost of capital by raising a portion of it from debt rather than equity. But it is rarely wise to raise all of it from debt because the lower the equity ratio, the higher the risk to creditors and the greater the risk-premium they charge. At some point, the cost of lowering the equity ratio exceeds the benefit. When that point is reached, the equity ratio is just right.
Alas, government guarantees to bank creditors have rendered this simple way of answering our question obsolete. When bank creditors’ losses will be covered by money extracted from taxpayers, the creditors charge no risk premium and banks can profitably increase their leverage without limit.
The ICB seeks to perpetuate this market distortion. By “ring fencing” the retail banking parts of universal banks, it removes any doubt that their creditors enjoy a government guarantee, and any commercial incentive for limiting the banks’ leverage. Hence the need for a regulated minimum equity ratio.
But the ICB’s new minimum, like the lower one it replaces, must have been plucked out of thin air. The ICB cannot know if its new minimum ratio will make banks too safe or leave them too risky. The reason is not peculiar to banking; such ignorance is an inevitable consequence of replacing prices with commands.
All product features come at a cost. Should leather upholstery be added to some basic model of car? It should if consumers value leather seats more than they cost to provide. But if the government subsidises upholstery, so that consumers cannot accurately signal how much they value the various options, the decision must be made arbitrarily.
The equity ratio of a bank is a product feature for investors. The best ratio depends on the cost of providing it and on how much creditors value it, which can be seen in the prices they are willing to pay. Subsidise bank debt with government guarantees, however, and this information is lost. We no longer get a range of bank equity ratios reflecting the variety of risk-return trade-offs to be found in the population. We get a single ratio arbitrarily set by central planners. It would be a miracle if the ratio they impose were right for even a single bank for a single month.
The ICB is like someone who smashes the lights and then starts ordering people around on the ground that, otherwise, they will bump into each other. It seems to have forgotten that, when you put everyone in the dark, that includes yourself.
Jamie Whyte is a senior fellow of the Cobden Centre.