Andrew's response to

Andrew Smithers
Financial Times - Economists' Forum, 6th July 2009

Andrew Smithers' response to Martin Wolf's Economist Forum post entitled The cautious approach to fixing banks will not work

Martin’s article today claims that the cautious approach to fixing banks will not work and then advises a cautious approach in the form of a lengthy transition to high capital ratios.

Even if current balance sheets are assumed to provide a fair representation of the banks’ net worth, the scale of the required increases in equity is well beyond any reasonable expectation of the amounts that can be provided from retained profits. Bankers know that they will have to have higher equity ratios in the future, but do not have to have them now. This provides a strong incentive to reduce banks’ balance sheets, thereby constraining credit growth and imperilling economic recovery.

The correct government policy on both sides of the Atlantic is therefore to insist that banks have much higher equity ratios, for these higher ratios to be implemented quickly and to offer public sector underwriting so that banks, however unwillingly, will be able to raise the required equity, even if the issues strain the capacity of the private sector market.

If Martin were claiming that this is the correct policy but an unlikely one, I would agree. There are several reasons why “correct government policy” is unlikely.

(i) Bankers are opposed to it and have considerable political influence. This is not just through their political contributions, but also because politicians look to bankers for advice on banking issues. It is of course absurd that bankers, whose failure to understand the issues has made a large contribution to current problems and who have massive conflicts of interest, should advise on their solution. But, as they do, bankers are a major obstacle to clearing the mess that they have helped create.

(ii) As there are reasonable doubts about the capacity of capital markets to fund the quantity of new equity issues needed, governments would need to stand behind the issues, certainly as underwriters and quite probably as investors. This meets political opposition from populist sentiment, being seen as “bailing out the banks”, and political opposition from bankers, who see it as expropriation rather than bail out. It will also, unnecessarily, raise worries about adding to the national debt.

(iii) Any single country that forces the issue by requiring higher capital ratios will be concerned that they will damage the competitive position of their financial services industry. International agreement on change is thus highly desirable, if not essential, and will be neither easy, nor speedy.

It is equally difficult for any convincing assurance to be given to bankers that they will not be required to increase capital ratios for many years to come.

(iv) Governments cannot bind their successors.

(v) Such a statement by any one government could be condemned as making international action more difficult.

(vi) Political promises are more likely to be broken than believed.

(vii) It would be open to attack, as set out above, as the wrong policy.

The incentives to politicians to avoid “courageous” action are strong and hopes that it will be unnecessary rise with talk of green shoots.

The likely outcome is no action at all; neither will credible assurance be given to banks that they will not be required to have more capital for many years ahead, nor will steps be taken to force them to have more capital now. We will have inaction, aka “the cautious approach to fixing banks’ problems”, which Martin rightly thinks will not work. Banks are therefore likely to shrink their balance sheets and we are likely to discover whether this will inhibit economic recovery.