Keeping Money in the Bank

The Paradox of “Safe” Banking

This article was first published in Quantum magazine.

Making banks safe is easy. Regulators just have to insist that they are loaded high with capital and prevented from lending to anyone more risky than a triple A-rated sovereign. That way no bank will collapse ever again.

But safe banks are also dysfunctional. A successful banking system is one that mediates between short-term lenders (depositors) and long-term borrowers (companies, governments, homebuyers), and in which banks assess their risks and set their margins sufficiently well to get paid back, to return depositors’ money, and make a profit into the bargain.

Alan Greenspan, the former chairman of the US Federal Reserve—who has been criticized for keeping interest rates too low and allowing asset bubbles to form prior to the crisis—said, as far back as 2001: “To do our jobs well, we should understand that the essential economic function of banks is to take risk, and that means mistakes will sometimes be made. A perfectly safe bank, holding a portfolio of Treasury bills, is not doing the economy or its shareholders any good.”

Many bankers now fear that, in reaction to the crisis, politicians and regulators will make banking systems too safe. Under the Basel regime, which has been the international standard since 1988, banks are required to have a capital ratio of 8% of assets, of which 4% has to be in the form of equity or reserves (Tier 1—the most loss-absorbing type of capital).

Since the crisis a whole raft of recommendations has come from policymakers on the need for banks to hold more capital, especially against their trading books and also when they securitize their assets. The trend to securitizing assets over the past couple of decades—taking them off balance sheet and funding them with the issuance of new bonds—has been cited as a major factor in causing the banking crisis. Most US subprime assets were funded by this method.

Totting up the various initiatives, either from Basel or from national regulators such as the Financial Services Authority (FSA) in the United Kingdom, analysts have arrived at a Tier 1 figure of 11%—nearly three times the current level. If this became a reality, banks would be hard-pressed to provide customers with credit as economies pick up. The Western economies at least, where these rules are likely to be enacted most stringently, will experience much more sluggish growth if their banks are left to labor under a capital-heavy regulatory system.

The chairman of the FSA, Adair Turner, recognizes this, but in a postcrisis environment he, like other regulators, will be leaning on the side of caution. His view is that the “optimal level (of capital) should in theory strike a balance between the higher cost of intermediation which increased capital requirements may tend to impose and the reduced risk of instability which higher capital will ensure. Having learned over the last year how huge are the economic costs of instability, that pushes the balance in favour of higher overall capital requirements. The open issue is how much higher.”

The politicians and regulators are operating in uncharted waters, and it is a near certainty that, in putting together new capital requirements for banks, mistakes will be made, creating new distortions and possibly the basis for the next crisis.

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Measures that Worked in 2008–09

But there are better or worse sets of rules, and some regulators have come through the crisis looking rather impressive. The Bank of Spain, for example, kept Spanish banks safe by forcing them to make provision in the upward part of the business cycle, giving them a capital cushion for when the economy turned down and nonperforming loan figures rose.

Canadian banks were helped by the successful use of a leverage ratio to prevent assets growing disproportionately to the amount of capital held. Brazilian banks were required to hold high capital as well being subject to high reserve requirements (the amount of funds as a proportion of deposits that they have to lodge with the central bank and which therefore cannot be used to support lending growth). As Brazil has experienced banking crises in the recent past, its regulators were fairly restrictive and their caution paid off. Brazilian banks emerged from the crisis in good shape.

Before the crisis these regulators were often criticized for being overly conservative and for preventing economic growth. American politicians for the most part hailed the expansion of credit to subprime borrowers as the beneficial workings of the free market and the spread of popular capitalism.

In Germany, by contrast, homebuyers were prevented from borrowing more than around 60% of the value of a property. As a result home ownership as a percentage of the population is lower than in countries with a more liberal approach, such as the United Kingdom. This encapsulates the dilemma for bank regulation—it’s essentially a growth versus risk dichotomy.

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What Caused the Crisis?

Critics of the G20 say that it has incorrectly identified hedge funds, tax havens, and bankers’ bonuses as principal causes of the crisis and so as being ripe for reform. They say the first two had nothing to do with the crisis and that bankers’ bonuses were at most a subsidiary factor. However, campaigning against these bonuses has political mileage for the politicians.

The reality is that there will be positive and adverse consequences whichever part of the financial market is targeted. Some have focused on the huge trading operations carried out in universal banks and how they have endangered the more conventional parts of the bank.

An earlier change to the accounting rules that stipulated that banks mark trading book assets to market (assign the current market value to them) enlarged the problems arising from the market upheavals, as the losses immediately impacted on the balance sheet.

But another factor was involved. The traditional method used by banks and regulators to evaluate risk, known as the value-at-risk (VaR) technique, did not work well in the crisis. One reason was the growing amount of trading book assets which—as well as having market risk—also contained elements of credit risk (credit derivatives, for example). Another trend has been the growth of structured products that are less liquid than other traded instruments.

The response of the Basel regulators has been, naturally enough, to demand more capital, especially for those banks using internal models to assess their trading book risk, as allowed under the Basel II regime currently being implemented. Calculations done by the rating agency Fitch suggest that these changes could result in banks’ trading book capital increasing by 4.5 to 5 times.

Table 1. Effect of market turbulence on trading book capital. (Source: Fitch)

Measured using variance–covariance VaR approach and normalized on basis of 100 for pre-June data.

Fitch Ratings says that “although higher capital requirements are clearly warranted relative to current Basel trading book rules, the potential overestimation of capital charges on trading activities could…reduce financial institution participation, and therefore liquidity, in important financial markets; distort capital and resource allocation in ways that are not economically efficient; create disincentives for institutions to participate in certain profitable activities or markets that might provide important earnings generation and income-stream diversification; and make regulatory risk estimates and models less relevant for internal risk management purposes.”

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Securitization

Securitization has been the big growth story of the past decade, and in some senses it has been a way for banks to get around prevailing capital regulations. By offloading assets (initially mortgages, credit cards, and car loans—but later on flows from credit derivatives transactions) into special-purpose vehicles, banks could save on capital and lend it out again.

As time passed the quality of assets in the structures deteriorated, due diligence on the assets was reduced to a minimum, ratings were given to the bonds without having proper default histories of the underlying assets, and the leverage increased as financiers invented ever more complex structures.

When some of these structures began collapsing, it turned out that many were not properly off balance sheet anyway, and that banks still had exposures to them. In some cases banks borrowed in the commercial paper markets to invest directly in the triple-A tranches of securitizations put together by other banks. When the commercial paper markets shut down, they could not refinance their positions.

Once again the regulators’ response has been to raise capital requirements—even though much of the blame for the sector’s difficulties can be placed with the poor quality of assets (subprime mortgages) and the incorrect rating of the bonds.

In fact some of the capital arbitrage that banks were achieving by taking assets off balance sheet was set to disappear anyway as the new Basel II rules were introduced. But under a set of enhancements agreed since the crisis, more capital will be required for so-called re-securitizations—where the income streams from securitized bonds are securitized again in what are called collateralized debt obligations (CDOs)—as well as for the liquidity facilities that banks provide to securitizations.

As with every Basel initiative, the critical factor is how national regulators choose to apply it—and currently they are in a very cautious mood.

In Europe, Basel rules come to fruition through the European Union’s Capital Requirements Directive, and in May 2009 the European Parliament approved an amendment to force banks to retain 5% of asset-backed deals they originate and to prevent them from buying into securitizations that don’t comply with these requirements. This is known as “keeping skin in the game,” and it was vigorously opposed by banks and securities associations on the basis that it would make securitization unviable.

Charlie McCreevy, the outgoing European Commissioner for Internal Market and Services, commented: “On the now famous ‘5 per cent retention’ for securitisation, I’m pleased to see that the [European] Parliament has resisted the call from industry to do away with what they had only last year characterised as complete nonsense. I am delighted to say that the retention rule has emerged as something that is not nonsense but plain common sense. It is now recognised by the G20 as a key measure to strengthen the financial system.”

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Hybrid Capital

Another hugely controversial area is that of hybrid capital. The original thinking behind the Tier 1 ratio was that it had to consist of the most loss-absorbing forms of capital, such as equity and reserves. This was reiterated in September 2009 by the Group of Central Bank Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision.

They were reacting to a trend over the past decade for banks to issue hybrid forms of capital designed to have the loss-absorbing features of equity but to pay bond-like returns—a fixed income stream until an implicit “maturity date” when they would be called and investors paid back.

Hybrid bonds were constructed so that regulators would treat them as equity, while to investors they were bonds in terms of both creditor status and tax advantages. When the crisis hit, hybrids in general failed to perform the role of equity.

In some cases, banks did not invoke their right to defer coupons on hybrids for fear of alienating investors; in other cases, deferring on a hybrid was conditional on a bank also deferring on another kind of bond (they were said to be “pari passu” and have the same rights), which effectively relegated them back to debt status.

Gerry Rawcliffe, group credit officer with Fitch Ratings, says that “realistically no-one should expect hybrids to be more permanent than common equity, which is typically subject to buy-backs. When you cross debt genes with equity genes, it has not been as clear as it should have been which dominate under stress.”

The fact is, however, that hybrid capital—like securitization and trading—has become a central feature of the contemporary banking landscape, involving huge volumes of issuance to specialized investors. Indeed, much of the government capital used by faltering banks to recapitalize was in hybrid form, and it would be a huge challenge to refinance all this as pure equity. The genie is out of the bottle and will not easily be put back inside.

Table 2. European financials hybrid debt issuance. (Source: Dealogic)

* Year to date at the time of writing

All the same, regulators are going to be increasingly skeptical about the hybrid concept. Danièle Nouy, secretary general of the Banque de France’s Banking Commission, argues: “In Europe new rules have just been introduced to ensure that hybrid capital is more effective in the future at absorbing bank losses on a ‘going concern’ basis. In particular, it is now explicitly required that appropriate mechanisms be in place to allow for the principal, unpaid interest or dividend of the instruments to absorb losses and not hinder the recapitalization of a distressed firm.”

The US government, when it stress-tested its banks in the wake of the crisis, excluded hybrid instruments in its assessment of capital strength. George French, deputy director of bank supervision policy at the Federal Deposit Insurance Corporation, said that “certain hybrid securities have been allowed Tier 1 capital status for US bank holding companies (but not for insured banks), but consistent with their nature as debt instruments, these securities do not provide the same level of capital support as common equity or non-debt capital.”

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Case Study

CoCo Bonds in the United Kingdom

The choice of regulatory regime is further complicated by the ability of banks to come up with new and innovative solutions, often with far-reaching consequences that neither they nor the regulators fully perceive at the time.

In this case, the United Kingdom’s Lloyd’s Bank, which is 43% government-owned, has devised a form of hybrid known as contingent convertible or CoCo bonds. The European Union has objected to banks rescued by the state paying coupons on hybrids, so, as a way out, last November Lloyds exchanged existing hybrids into CoCos, which convert to equity if the bank’s Tier 1 ratio falls below 5%.

“We expect that there will be investor interest in contingent capital securities, but we do not know whether they will remain a niche product or become a more mainstream part of the bank capital funding market,” says Standard & Poor’s credit analyst Michelle Brennan. “This will affect the capacity of the banking sector to rely on these instruments.”

Analysts are concerned that the Tier 1 ratio, at which the bonds convert, may be set too low. With banks tending to hold higher amounts of Tier 1, and being pushed by regulators to hold more, by the time the level has fallen to 5% the government might already have felt it necessary to intervene.

On the other hand, if it were set higher the CoCos would become expensive and unattractive to banks. No one should be under any illusion that the CoCo solves the fundamental hybrid problem—of trying to meet the criteria of investors, the banks, and regulators—satisfactorily.

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Liquidity—But How Fast?

Some analysts have also commented that in a crisis the issue is not so much a question of how much capital a bank has but how liquid it is—in other words, how quickly can it sell assets to realize capital to set against losses or to repay creditors. Many of the bonds created by the new securitization structures proved to be very illiquid and ineffective in tough circumstances. Now, led by the FSA, there are moves to make banks hold a greater share of government bonds, which can be easily realized for cash.

Cynics have countered that this will also suit the needs of hard-pressed Western governments, which need to issue huge volumes of sovereign bonds to pay for the cost of bailing out the banks. By insisting on this as a part of a new liquidity regime, they have effectively created instant demand for their bonds. In any case, such stipulations will reduce the amount of the balance sheet available for mortgages and small business loans, and so further slow credit growth.

One of the major criticisms of the Basel regime is that if all regulators follow a similar system, it encourages all banks to do the same things at the same time. When markets are going up, the banks’ risk models tell them to hold less capital, and when markets go into reverse, the banks all scramble to raise capital holdings together; in other words, it encourages procyclicality. Among regulators, the Bank of Spain stands out as the one that, by forcing banks to make provision in the boom period, best prepared for the crisis.

This issue was also addressed by the Basel Group of Central Bank Governors and Heads of Supervision in September 2009. They came up with measures to improve capital conservation by limiting dividends, share buybacks, and compensation, and by promoting more forward-looking provisions based on expected losses. Simply put, it means keeping more money in the bank and paying out less in bonuses and profits—which also means less in tax receipts for host governments. Making banks safe is clearly a costly exercise for everyone involved.

Not only that, but it is in some ways a futile exercise unless the macroeconomic conditions that formed the background to the crisis are also tackled. This is a much more thorny issue as it involves major changes to national economic policy. The G20 has undertaken to do this using the International Monetary Fund as the surveillance mechanism.

For—unless the G20 powers can get this right—excess flows of global liquidity will continue. Right now they are pouring into emerging markets such as Brazil, resulting in currency overvaluation. The Western banks may be safe and holding more capital than they need, but there are plenty of other weak links to be tested.

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Factors Affecting Banking Regulators

Banking has always had a political dimension, so regulation is nothing new. Historically, banks were used by kings and dictators to finance wars; today they are used to promote certain industries or policies. All the same, there are better and worse outcomes of government policies for banks.

For most of the past several decades the financial sector has also been highly regulated, so again this is nothing new and banks have invested a good deal of time and energy in getting around the regulations—often with the tacit support of politicians.

Macroeconomic conditions have a major economic impact on banks. The single biggest cause of the current crisis was the excess liquidity resulting from the reinvestment of the foreign exchange earnings from Chinese trade surpluses into US Treasury bonds. This lowered yields and led banks to search out higher-yielding and riskier assets in order to make the returns their investors had become accustomed to.

Moreover, banking crises are endemic to capitalism, and to perfect a system that would prevent them completely is probably beyond the wit of humankind. Also, banks are often asked to perform two contradictory actions: to be “utilities” in providing banking services to the community at large, but at the same time to maximize shareholders’ returns—for example, to raise capital at the same time as increasing lending, which has been the favorite response of politicians in the current malaise.

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