Ring-fences and higher capital requirements work better with disclosure

The members of the Independent Banking Commission know that a ring-fence between retail and investment banking and higher capital requirements by themselves are not adequate to restore financial stability.  They know that disclosure as defined under the FDR Framework is also required.

Jeremy Warner wrote a terrific column in the Telegraph that lays out the inadequacies of a ring-fence between retail and investment banking and higher capital requirements that disclosure cures.

Whenever a big bank becomes insolvent, the Chancellor is faced with a stark choice. Either you can bail the bank out with taxpayers’ money, his officials will tell him, or tomorrow there will be mayhem in the markets followed by economic collapse. With the gun placed firmly against his head, the Chancellor will always opt for the apparent lesser of the two evils, and order a bail-out. 

That’s what Alistair Darling did, first with Northern Rock, and then later with Royal Bank of Scotland and HBOS. There were any number of more generalised bail-outs of the banking system in between, in the form of government-sponsored liquidity support. 

The scandalous nature of this “non-choice” is all too familiar. Highly paid bankers are always the first to lecture the rest of us on the importance of market disciplines, as well as threaten us with the ultimate sanction of bankruptcy, but they are not subject to the same disciplines themselves.

This blog has frequently explained that the reason bankers are not subject to market discipline is because the financial regulators have an informational monopoly on bank's current asset and liability-level data.  Without this data, market participants cannot do their homework and adjust the price and amount of their exposure based on the risk of the individual bank.

This point bears repeating.  Market discipline in the form of higher costs to access funds impacts the risks that bankers take before they become insolvent.  The regulators' information monopoly interferes with the proper functioning of market discipline.

Their position at the heart of the payments system means that, in extremis, the taxpayer always has to bail them out. The profits of finance get privatised, but the losses, it seems, are invariably nationalised. 

Higher capital requirements and a ring-fence between retail and investment banking redirect the losses away from the taxpayer and back onto the bankers and the investors.

How to rid the taxpayer of the “too big to fail” problem has therefore become one of the chief objectives of banking reform. 

The humongous size of Britain’s banking sector, with liabilities more than four times bigger than GDP, makes the issue particularly acute for the UK. Britain struggled to accommodate the last round of bail-outs; it could not afford a second. 

Or as the Governor of the Bank of England, Sir Mervyn King, put it in his Mansion House speech last night, “Until we find a solution to the 'too important to fail’ problem, the size of our banking system will remain too large for the UK taxpayer credibly to support in future.”

This blog has frequently explained that disclosure of current asset and liability-level data is the lowest cost and most efficient way to reduce the risk of the banking sector.

Risk and not size is what is important.  Which poses a larger threat to the UK taxpayer, a bank invested in $500 billion in short term UK government debt or a bank invested in $250 billion in subprime mortgage backed securities?

Why does disclosure result in a less risky banking sector?  Market discipline.  The return that investors require is related to the amount of risk a bank takes.

Banks with higher risk will see their cost of funds, both debt and equity, increase.  Increasing the cost of both debt and equity reduces a bank's share price.

• An increase in the cost of debt means the bank's profitability will decrease (the return on the assets is independent of how they are funded).  This should result in a lower share price.  

• An increase in the cost of equity means that for the same level of income, investors are willing to pay less for the shares.  This should result in a decline in the share price.  

Management has an incentive to try to maximize and not minimize the share price of the bank.  As a result, management has an incentive to reduce the riskiness of the bank and can select how it wants to do so.

Disclosure has a second mechanism that works to shrink the risk in the banking sector.  When a bank has to disclose all of its trading positions, it limits the size and profitability of these positions.  Imagine how much harder it would have been for Goldman Sachs to short the sub-prime mortgage market if all market participants could see its growing short position.

George Osborne, the Chancellor, believes he has found part of the answer in the Independent Commission on Banking’s (ICB) suggestion of a limited degree of structural separation, so that the domestic, retail part of the bank is ring-fenced and separately capitalised from its so-called casino operations. 

The theory behind this proposal is that however reckless the investment bankers become, the retail bank, or the bit that’s important to the UK economy, will always be safe. When the bank as a whole gets itself into trouble, the retail bank can be cordoned off, leaving the casino bankers to pay for the consequences of their own follies by going bust in the normal way. Furthermore, use of the retail bank’s balance sheet to play at the roulette wheel of international finance will become very much more difficult, if not outright impossible. The Chancellor will never have to face the impossible choice again. 

It all sounds a great idea in theory, but will it work in practice? Frankly, I’m sceptical. Forgive the cliché, but the devil is always in the detail, none of which has yet been spelt out, and which when translated into practice threatens to be extraordinarily costly. 

Actually, the direct benefit of providing disclosure exceeds the cost of disclosure.

Just as market discipline punishes risky banks with higher costs, it rewards low risk banks with lower costs.  Low risk banks should want disclosure because as they emerge from behind the opacity caused by the regulators' information monopoly the market will reward them with a lower cost of debt and a higher share price (lower cost of equity).  This lower cost will more than offset the de minimus cost of providing disclosure.

What’s more, the whole concept is based on an unsatisfactory compromise between the objectives of safety and keeping the City competitive as a financial centre, which necessarily requires retention of the universal banking model in some form.

Actually, with disclosure there is no compromise between the objectives of safety and keeping the City competitive as a financial centre.  Would the City prefer to be known for its banks providing the best disclosure in the world or for its banks being attracted to it because they can hide what they are doing?

In the past, investors have shown a preference for gravitating to financial markets where there is the best disclosure since it is only with disclosure that investors can assess and properly price risk.

Ring-fencing is neither one thing nor the other – neither the full separation of functions that used to exist in the US under the old Glass-Steagall Act, nor full acquiescence in the universal banking model that exists virtually everywhere else. Depending on precisely what’s put behind the fence, the reform also promises to be anywhere between moderately and fiendishly expensive, further increasing the cost of credit and reducing its availability. 

Nor is it even likely that the ring-fencing will succeed in its public policy purpose of reducing or eradicating the potential costs of banking crises to taxpayers. The financial maelstrom of the last four years was as much a crisis in conventional banking, and in particular good old-fashioned commercial property lending, as it was in the overly aggressive expansion of the casino. On any realistic definition of a retail bank, both Anglo Irish and HBOS would have almost wholly fallen within the ring fence and would therefore still have needed bailing out. 

The ring fence would not in itself have prevented Royal Bank of Scotland going to the wall either. What, on the other hand, would have saved RBS is a 10 per cent capital buffer, combined with a regulator with the wherewithal to prevent RBS from further expanding its balance sheet at the top of the market by making high-risk overseas acquisitions. The Government is in danger of using a sledgehammer to crack a nut. 

Disclosure addresses the need to moderate bank management's behavior using market discipline before the bank becomes insolvent.  However, disclosure and market discipline do not prevent banks from becoming insolvent.  As RBS showed, sometimes management insists on screwing up.

Ring-fencing and higher capital requirements address how to clean up and allocate the cost if a bank does become insolvent.

But worst of all, far from removing the moral hazard of implicit taxpayer support for bank creditors, the ring-fencing enshrines it and makes it explicit. 

If everything within the ring fence is deemed utterly safe and guaranteed by taxpayers, then it won’t be long before bankers find ways of exploiting this public subsidy with ever more high-risk forms of conventional lending. The casino will merely switch from the barrow boys of the City to the Captain Mainwarings of the local branch network. 

Disclosure is the tool for regulators preventing the public subsidy from being exploited.  With disclosure, market participants, including the global regulatory community, can easily identify if risk is increasing (think IBM's "Watson" monitoring the current assets and liability-level data from the ring-fenced portion of these banks looking for increases in risk to notify regulators about).

Something plainly has to be done about the “too big to fail” problem, but does it really make sense to push through a restructuring that puts British banking at a disadvantage to overseas rivals while doing little to make the system fundamentally safer? 

It is one thing to reform an industry that has done untold damage to the economy, but to render it uncompetitive and oppressively costly, in punishment for a crisis whose chastening effect on behaviour already means it’s most unlikely to be repeated for a generation or more, doesn’t seem a sensible way forward. 

The combination of disclosure, ring-fencing and higher capital requirements promises to make banks in the UK more competitive and less prone to repeating a financial crisis.  A result I prefer over gambling on the chastening effect on behaviour from the last financial crisis.