Financial World, 1st February 2011
Companies’ balance sheets matter to their management, employees, shareholders and creditors. Bank balance sheets are vital for the whole economy. Creditors want strong balance sheets and management and shareholders want weak ones. Creditors keep debt in check by refusing to lend to the profligate. Banks’ debts are guaranteed by taxpayers so, however profligate banks are, their creditors don’t care. The interests of taxpayers and bankers are thus in conflict. But politicians represent taxpayers without always sharing their interests. Politics is expensive and rich bankers have made large contributions to political parties; as a result they have access to grateful politicians, who accurately meet La Rochefoucauld’s definition of gratitude as “a lively expectation of future favours”. Bank balance sheets are therefore at the heart of a conflict between the interests of taxpayers and of bankers. Politicians are the taxpayers’ agents, so we have an example of one of the most frequently encountered issues in economics, the agent-principal problem.
Bank balance sheets raise three different issues. The first is the subsidy provided by taxpayers’ guarantees. The second is the risk to the economy that comes from weak balance sheets and the third comes from the element of monopoly in banking services. Keeping these issues separate is essential, but it is also difficult because confusion is in the interest of bankers, who know that if you can’t win an argument, you can at least obfuscate it. It is also, I think, both kind and reasonable to assume that the incoherence of most bankers’ arguments arises from ignorance. Those running banks have, in normal times at least, no need to understand the economics of banking. Indeed such knowledge would in recent years, far from helping their careers, have been a major handicap. Banking has suffered from what is known to economists as adverse selection. The more a banker understood what he was doing, the more he would wish to stop and those who stopped were either discarded as poor contributors to profits or left banking of their own volition.
The guarantees that taxpayers provide to bank creditors is partly explicit but sometimes, as we have seen recently during the Irish crisis, it starts as implicit and becomes explicit because the government cannot afford the consequences of allowing banks’ creditors to lose money. A company whose liabilities are guaranteed by taxpayers has no need to have any equity (share capital) at all. If the liabilities of sweet shops were guaranteed, they would be found everywhere and their managers would be remarkably well paid for very little work.
By guaranteeing banks’ liabilities taxpayers are providing them with a huge subsidy. It has been estimated by Andrew Haldane of the Bank of England that the UK banks have, in recent years, received a subsidy equivalent to around $50 bn. a year.* This subsidy would have been less if the rules governing bank capital had been more stringent. We must therefore ask if we wish to subsidise banks, rather than say exporting manufacturers, sweet shops or no businesses at all. If we wish to continue, we must ask how heavily we wish banks to be subsidised. It is a marked success of bankers’ propaganda that this issue has been so little discussed. It is clear that if we don’t wish to subsidise banks their equity capital ratios need be increased, not by a few percentage points from their current level but by a multiple of where they are today.
Most of the discussion about bank capital revolves around the impact that increasing it is likely to have on the economy, seen from two different perspectives. The first is that of economists and regulators who don’t want another financial crisis and who think that the more capital that banks have the less likely will another crisis be. Bankers have the opposing viewpoint. They don’t want to have to increase their capital and claim that, if they have to do so, borrowers will have to be charged more, so that the economy will suffer as companies will invest less and more of them will be driven into bankruptcy.
Economists who have looked into this question, such as Ray Barrell of the National Institute of Economic and Social Research, have generally concluded that the additional costs will be small. But, like all economic calculations, the cost of changing things depends on what you assume and in particular whether you assume that banking is a competitive industry. I think that there is overwhelming evidence that it is not. I am therefore doubtful whether increasing equity ratios would increase borrowers’ costs at all. Data published by the Bank of England show that from 1921 to 1971 the return on the equity of UK banks had averaged just over 7% p.a. and since then it has averaged around three times as much. The long-term real return on shares has been around 5% to 6% and so the return of 7% before inflation is almost exactly what should be expected from any industry, unless it had been operating under peculiar and special circumstances. The tripling of more recent returns therefore needs to be explained rather than the earlier returns. There are two likely candidates. First is the high volatility of banking profits which have accompanied the rise in returns. The second is that banking has become an oligopoly and that as a result it has been possible to charge margins on loans and other products which are much higher than they would have been if banking had been a fully competitive industry.
Whichever of these explanations is correct, the conclusion is that additional capital requirements need not have any impact on the charges made by banks. Adding to capital will reduce the volatility of profits and if this has been the cause of high returns it will reduce the need for them. If sufficient capital is introduced to reduce volatility to its pre-1971 level, then this would have to be more than three times the current requirements for there to be any adverse impact on bank charges. If the high returns on banks’ equity are the result of inadequate competition, then no additional costs would result unless banks are failing today to exploit their monopoly power to the full, which seems inherently improbable. In addition of course, successful moves to improve competition would actually lower banks’ charges. Since bankers argue that higher costs would hurt the economy, they would be hard put to deny that lower costs resulting from greater competition would be a public benefit.
The issue of competition is central to the issue of bank capital for two other reasons. The first is over the vexed issue of bankers’ remuneration and bonuses. There are two possible reasons why bankers earn more than those engaged in other trades. They may be more skilled and able, or they may operate in an uncompetitive industry. If they earn a fair reward for their skills, there is no apparent justification in controlling their pay. If the industry is uncompetitive, then controlling their pay is to address the wrong issue. Increasing competition is desirable anyway and would deal with the issue of bankers’ pay in a fair way. Bank capital and competition are thus connected. The evidence that banking is uncompetitive lies not only in the return on banks’ equity, which applies not just in the UK but in other countries, such as the US. Other evidence can be seen from the marked increase in the concentration in the industry. For example, the 3 largest banks in the US had 15% of the industry’s assets in 1994 and 40% in 2007, while in the UK the largest bank’s assets have risen from 50% of GDP in 2000 to 140% in 2007.** Industries with marked barriers to entry will tend to be increasingly concentrated. A key sign of inadequate competition is therefore evidence that the number of players has fallen.*** To increase competition we need to offset the competitive power of large banks. The simplest way to do this is to require large financial institutions to hold higher equity ratios than smaller ones and to raise the difference until large institutions start voluntarily to split themselves into smaller units.
The case for changing the current capital requirements is thus very clear. A very large increase in the minimum equity ratio would significantly reduce the risks and subsequent costs of the next financial crisis. If it were combined with the requirement that the ratios for large institutions should be even greater than for small ones, it should both increase competition and reduce the risk that an institution has to be rescued because it is too big to fail. The costs of such changes will be small and the benefits great.
Three arguments seem to have been, so far, highly successful in impeding progress towards these sensible and desirable solutions. The first is that it will raise borrowing costs. The second is that a sharp increase in the requirements will inhibit lending and thus economic recovery. The third is that the business will leave the UK and go abroad.
I have set out why I think that first of these arguments is extremely flimsy. The second, which was unfortunately accepted by those who agreed on the Basel III regulations, shows I think a complete misunderstanding of banker’s psychology and likely behaviour. But I must admit that the third has a wicked logic.
The idea that allowing bankers lots of time to increase their equity capital will encourage them to lend strikes me as so absurd as to be mystifying. Bankers don’t want to increase their equity capital by new issues, or by paying low dividends and bonuses. The natural result of telling them that they will need higher capital ratios in the future is for them to plan to trim their balance sheets steadily in the years ahead so that they don’t need more capital, not to increase their capital so that they can increase their lending.
The threat of going abroad is different. It is the City of London’s best argument and, if honestly presented, it is rather shocking. When stripped to its essentials, the argument is that finance is an uncompetitive rent gouging industry which is therefore against the public interest for the world as a whole. But it is our business and, so long as we can gouge the profits from foreigners, we should leave it alone.
In the debate over new regulations for equity capital, the banks won the first round. They successfully sold the argument that serious reform would damage growth. I think, however, that their success is fragile. Only a few weeks after the Anglo-Irish Bank and the Bank of Ireland were announced to have passed their stress tests, the Irish crisis demonstrated that the tests were designed to be passed rather than to be useful. We badly need much larger equity ratios in banks before the next crisis strikes and this has been clearly demonstrated by recent events.
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*The $100 Billion Question, by Andrew G. Haldane published by the Bank of England March 2010.
**See The $100 Billion Question op. cit.
***See Firm Stability and System Stability: The Regulatory Delusion by Geoffrey Wood and Ali Kabiri, a paper for the Conference on Managing Systemic Risk held at the University of Warwick, 7th to 9th April, 2010.