Regulators show that bank capital requirements are pro-cyclical

In case there was any doubt over whether the management of bank capital requirements by regulators has been pro-cyclical and increased the economic downturn brought on by the solvency crisis, Larry Elliott ended it with his Guardian column.

Banking has become, rather like the chapter on the fall of the rupee in Oscar Wilde's The Importance of Being Earnest, "somewhat too sensational". 

We shall see on Monday what the government has in mind to make the industry less racy when it gives its response to the report headed by Sir John Vickers. There are unlikely to be many surprises: the plan will be to ringfence the retail operations of financial institutions from their investment banking arms but no break-up. 

Just as importantly, in the short term at least, will be whether ministers accept the recommendation by Vickers that banks should hold far more capital so that they can more easily ride out financial storms. The minimum suggested under the internationally agreed Basel III accord is for a 7% capital cushion but Vickers says it should be 10% for UK banks. 

It's not hard to see why regulators have demanded tougher rules. Banks were over-extended in the good times and operating with far too little capital.... 

What has happened subsequently is a classic case of slamming stable doors after the horse has bolted. Banks had too little capital in the good times and the danger is that they will be holding too much capital in bad times.... 

The argument is that bigger capital buffers are needed to deflect the unwelcome attentions of the credit-rating agencies, who, somewhat belatedly, are now adopting a rather more forensic approach. Banks with high capital ratios will be seen as safe, and will therefore be able to attract funds from other banks should they need to do so. 

Raising capital requirements today does not fool market participants into believing the banks are safer.  Market participants know that banks have significant exposures to troubled credits.

What the regulators achieve by setting a meaningless 9% Tier I capital ratio target is the opportunity to make misleading disclosures to the market,to run up a flag that confirms the financial system is still completely broken and remove any doubt that they are not up to the task of promoting financial stability.

What policymakers at the European Banking Authority (EBA), the Financial Services Authority (FSA) and the Bank of England want is a financial system that is strong enough and stable enough to fulfil its basic function of lending to the private sector. What they fear is that the less well-capitalised banks will fail, bringing the better-run banks down with them. 

What regulators want is what ultra transparency would provide.  A strong, stable financial system that fulfills its basic function of lending to the private and public sectors.

This all sounds fine in theory, but it is working out less well in practice. How do we know? 

One clue was the special swap arrangements announced by central banks last month, which allowed banks to access money cheaply. Another was the European Central Bank's announcement that it would provide unlimited three-year loans to commercial banks and significantly relax collateral rules. This is not, to put it mildly, a sector in rude health. 

In the UK at least, questions are now being asked about the wisdom of ratcheting up capital requirements on the grounds that they threaten to become dangerously pro-cyclical. At this stage of the economic cycle, when demand is low and credit hard to obtain, banks should be reducing their capital ratios so they can lend more. Insisting that they hold more capital means they call in loans, sell assets and lend less. In monetary policy terms, it is the equivalent of seeking to balance the budget in a slump. 

The position in the eurozone is worse than it is in Britain for three reasons. First, they are already operating in an environment where budgetary policy is pro-cyclical (and likely to remain so permanently as a result of Angela Merkel's fiscal stability pact). Second, the new rules for capital have been buttressed by tougher regulations governing the proportion of a bank's assets deemed to be liquid, normally defined as something that can be converted into cash without significant loss. One of the assets that has been designated highly liquid is European sovereign debt, and UK banks have less of this toxic waste on their books than their continental rivals. 

Finally, European banks do not have the benefit of a full-scale quantitative easing programme to assist them, and – because it is hard to raise money by selling new shares in the currentenvironment – are now involved in a fire sale of assets to raise the €115bn (£137bn) of additional capital that the EBA has said they need to make themselves secure. 

Louise Cooper, of BGC partners, said last week that in total European banks had pledged to cut assets by more than €950bn in the next two years. "That is a huge amount of deleveraging. In the current environment, these sales will have to be of profitable businesses and quality, performing loans."... 

"The banks will have to sit on the rubbish as it is unsellable," Cooper says. "Expect to see more and more evidence of banks deleveraging, selling assets, shrinking their businesses to raise capital. This does not bode well for the health of the European banking industry, or the prospects for a damaging credit crunch."

A point this blog has made repeatedly since the regulators decided that the market could be fooled by compliance with a meaningless bank capital ratio.

The UK is not immune from what is happening across the Channel and banks face the same sort of pressures to deleverage, albeit not so severe. 

This is now becoming a live issue for the Bank of England's financial policy committee (FPC), which is supposed to enhance financial stability by "identifying, monitoring and taking action to remove or reduce systemic risks".... 

Instead, the big question for the FPC is whether capital requirements on UK banks are too tight, too loose or just about right. The correct answer to that question is that they are too tight and need to be loosened in the short term even if they are to be tightened over the medium and long term.

What about the question of whether bank capital requirements should be dropped all together.

If banks are required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, capital and liquidity requirements don't add much value.  Market discipline will force banks to hold capital that reflects the risk of the bank.

More important, though, would be how such a message would go down in the financial markets. Would such a step be seen as a prudent response to changing circumstances or would it be seen as an admission that UK banks have big structural problems, thus creating the panic the authorities are seeking to avoid?

Actually, judging by the buyers' strike that is evident in bank stocks, it is clear that the market already thinks the UK banks have big structural problems whether they are required to hold more or less capital.

The fact is that market participants cannot tell if they are solvent because the banks' current level of disclosure leaves them, as the Bank of England's Andy Haldane observed, looking like 'black boxes'.

Until banks are required to provide ultra transparency, capital is meaningless.  Given this fact, regulators should quit demanding more of it and providing banks with an excuse to create a regulatory induced credit crunch.