Bank of England's Robert Jenkins: Let's make a deal, Part II

For anyone who hasn't read the Bank of England Financial Policy Committee member Robert Jenkins Let's make a deal speech, I recommend reading it as he thoroughly debunks relying on bank capital or regulators to preserve financial stability.

Banks take risks.  When more risks go right than go wrong, the result is a profit.  At other times a bank's equity capital absorbs the loss.  If there is not enough capital there is one less bank - or one more call to the taxpayer.

Perhaps Mr. Jenkins missed the fact that in the greatest financial crisis since the Great Depression, bank book capital levels have been remarkably constant and at the same time the call on the taxpayer has been quite significant.

How could this be if the bank's equity capital is there to absorb losses?

Because the policymakers, at the urging of the financial regulators and the bankers, adopted the Japanese model for handling a bank solvency led financial crisis.  Under the Japanese model, bank book capital levels are protected at all cost.  Hence, the reason that bank book capital has been remarkably constant and the taxpayers have been shelling out money like crazy.

Mr. Jenkins also observes that if there is not enough capital then either the bank is closed down or the taxpayers have to recapitalize the institution.

This completely ignores how a modern banking system is designed.  With deposit insurance and access to central bank funding, banks are able to operate and support the real economy even when they have negative book capital levels.  Since they can continue in operation, they can retain 100% of pre-banker bonus earnings to rebuild their book capital levels.  As a result, there is never a reason to call on the taxpayer.

Of course, some risks are riskier than others.  It follows that one should have more capital to support the riskier activities and less for the less risky.   This in a nutshell is the basis for the Basel rules governing global banking.  This approach produces a system of “risk weightings” for bank assets. ....   

Will it work?  That depends on the judgement of those “bullies” in Basel....

Translation: the stability of the financial system is dependent on regulators.  Ok, how did they perform leading up to the current financial crisis?

Well, let's take government bonds.  You will have noticed that some sovereigns are safer than others.... The Basel Committee of the day did not think so.  No capital was required for what was deemed to be a risk free asset.  Bad call: the write-down on Greek government bonds was 74%.  

Next, let's consider mortgage lending.  Do housing prices always go up?  No.  Might they sometimes go down?  Yes.  How much might they decline?  

1. 5%
2. 10%
3. 20%
4. All of the above?  

“All of the above” would be a reasonable response - although a citizen of the Spain, Japan or the US of A might raise the ante.  So what level of loss did the pre-bust Basel rules implicitly assume?  Put more simply, how many pence of loss absorbing equity do you think banks had to have to support a 100% loan-to-value mortgage?  5 pounds per 100? 100 pounds per thousand? Answer: 86 pence for every 100 pounds of loan.  

In other words, the regulations required less than 1% of loss absorbing capacity for mortgages with no money down.....

The regulators' performance track record is awful.

Yet for your info, the new rules (that is the new improved version of Basel II which was the new improved version of Basel I) demand 135 pence of equity in support of every 100 pounds of similarly rated CDOs squared - a loss absorbing capability of less than 1.4% for a risk that most rating agencies, regulators, bankers and investors misjudged. Oh, and by the way, sovereign bonds may still register as zero risk. 

The revised capital requirements do not inspire confidence.

Fortunately Basel III introduces a backstop.  A bank’s total leverage will be capped – at ahem, 33 times. Thirty three times leveraged!...

The total leverage ratio cap is US Treasury Secretary Tim Geithner's proudest regulatory accomplishment. Given the size of the losses Mr. Jenkins discussed, the cap has been set where it will do nothing.

The unavoidable conclusion is that current bank capital standards are unlikely to contribute anything to financial stability.

Next, Mr. Jenkins looks at the performance of the regulators.

And yes, when it comes to culpability the regulatory establishment is not exempt.  I have not heard many bankers accept blame for the crisis but quite a few within the regulatory ranks have acknowledged their failings.  But for avoidance of doubt, let me say it here and now: the regulatory establishment blew it!   

We messed up in two ways: first we misjudged the breadth and depth of the risks that many banks were running. Second, we misjudged bankers' ability to judge and manage those risks.  The latter is the more damning. 

How could we have been so dumb as to believe that bankers were so smart?  Both groups belong to the human race and the human race is hubris hungry and error prone. 

Mr. Jenkins has identified a fatal flaw with relying on regulators to preserve financial stability.  They are human and as such are error prone.

The Nyberg Report on the Irish financial crisis identified a few other reasons, like regulatory capture, why regulators should not be relied on to preserve financial stability.

Regular readers know that the major reason the regulatory establishment blew it is it failed in its primary mission which is to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so that investors can make fully informed investment decisions.

This falls under Mr. Jenkins description of regulators as hubris hungry and error prone.  Had this data in the form of ultra transparency been available, regulators could have tapped the market's analytical ability to judge risk.  Instead, they substituted their analytical ability for the market with disastrous results.