The reason for this low standard is the composition of the membership of the FPC. It is long individuals with a PhD in Economics.
In addition, there is no one on the FPC who publicly predicted our current financial crisis. I felt this might be a problem because in the absence of anyone who understood why the financial crisis occurred it was highly unlikely the FPC had the expertise to do anything to moderate the current crisis or prevent the next crisis.
Recall that the Queen also predicted that this was a problem when she asked the economic profession why it hadn't seen the current crisis coming. The very question suggests that perhaps by training economists are very poorly suited for understanding the financial system and what might cause a crisis.
At its one year anniversary, I am sadden to report that the FPC could not get over the 'do no harm' standard.
Here is the performance of the FPC as described by external board member Robert Jenkins in a Telegraph column.
The financial policy committee of the Bank of England is now one year old. Its purpose is to identify and, where possible, mitigate threats to the British financial system. Financial stability is the goal.
Over the past 12 months, systemic fragility and troubles in the eurozone have been the key threats.
Restoring confidence in the British banking system has been the priority.Given this priority, has the FPC done the only thing that restores confidence in a financial system and called for banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details? No.
Regular readers know that transparency restores confidence as it allows market participants to independently assess each bank. Confidence is restored because market participants trust their own analysis (whether they do it themselves or they hire a third party to do it for them).
That banks should build balance sheet strength has been the primary recommendation and today the country's banking system is among the better capitalised and funded.However, as everyone except the economists and other members of the FPC knows, bank capital is meaningless. This is not just your humble blogger's opinion, but an opinion expressed by the OECD.
The reasons why bank capital is meaningless are extremely well known.
First, we have suspended mark-to-market accounting. As a result, all those opaque, toxic securities and government bonds that still reside on and off the bank balance sheets have not been properly marked-to-market. This results in an overstatement of bank book capital levels.
Second, bank regulators have engaged in regulatory forbearance that has allowed the banks to keep zombie borrowers alive using 'extend and pretend'. Again, the banks have not taken losses and this too results in an overstatement of bank book capital levels.
So the primary recommendation for restoring confidence was to focus on a meaningless number as oppose to requiring the banks to provide ultra transparency and actually restore confidence.
Unfortunately, the primary recommendation to boost bank book capital also carried with it a well known and fully predictable toxic side effect for the real economy: a financial regulator induced credit crunch.
Since no investor is dumb enough to buy newly issued capital in a bank with large, undisclosed losses, to reach the higher capital ratios the FPC endorsed, banks had to shrink their balance sheets. The number one place to shrink a bank balance sheet and get the most bang for the activity is by reducing loans.
The toxic side effect of the FPC's primary recommendation was to support a financial regulator induced credit crunch. The FPC managed to take a situation where it was difficult for credit worthy borrowers to access bank credit and make it virtually impossible. As a result, the real economy has been starved for credit to support it. A clear violation of the "do no harm" standard.
Financial stability requires a healthy economy and a healthy economy requires financial stability.....Is this true?
Couldn't we have financial stability in a recession (I would think a recession qualifies as a 'sick' economy)?
committee members have questioned whether there might be a trade-off between the strengthening of bank balance sheets on the one hand, and ensuring sufficient credit availability on the other.
In other words, was there a choice to be made between safer banks and a stronger economy?
The discussion continues. To date, the following facts have informed the committee's recommendations:
• Confidence must be maintained in our banks without which the banking system will cease to function. Loss of confidence in the banking system is the single biggest threat to lending. The strengthening of bank capital and liquidity has been critical to restoring confidence.Every part of the highlighted text is not a fact, but is rather something that only economists believe! (Of course. they are encouraged in this belief by bankers who tell them it is true as the bankers are looking to be paid their bonuses.)
It is a belief that results in the incredibly destructive policies adopted under the Japanese model for handling a bank solvency led financial crisis.
Regular readers know that under the Japanese model, bank book capital levels are protected at all costs. This involves deception by the regulators and the adoption of policies like suspension of mark-to-market accounting and regulatory forbearance.
The result of these policies is that an accounting construct is held constant and the damage from excess debt in the financial system is forced onto the real economy. This burden is more than the real economy can support and results in contraction of the real economy.
As your humble blogger has said many, many, many times, the combination of deposit insurance and access to central bank funding forever ended depositors' concerns about the book capital level or liquidity of a bank.
(Let me give you two leading indicators of this simple fact. First, to date, no economist I have asked what is the capital or liquidity level of the bank they have their checking account at as of the end of last quarter has known the answer to the question. Second, every economist I have asked that has helped a child open a banking account has answer the child's question of how do they know they will get their money back from the bank by saying the government guarantees the child will get their money back.)
Deposit insurance shifts the concern to the issue of can the government make good on its deposit guarantee. If you live in Japan, the UK or the US, by definition the answer is yes because the government can always 'sell' bonds to the banks who can use these bonds as 'collateral' at their central banks to access funds that can be given to the depositor.
In the EU, until the politicians threatened to kick countries out and force them onto a new currency, depositors continued to believe that their governments would make good on their deposit guarantees. By introducing re-denomination risk, the EU politicians have lowered the value of the deposit guarantee (you still get your 'money', it is just paid back in a currency worth significantly less than the euro).
What everyone, except the economics profession, learned during the Savings and Loan Crisis in the late 1980s is that bankers will continue to lend even when there is little confidence in the solvency of their institution. Based on the commercial real estate boom that resulted from this lending, the link between 'solvency' and lending has been shown not to exist in the real world.
Our current crisis shows that bankers will also continue to gamble in the securities casino even when there is little confidence in the solvency of their institution. In short, since bankers are compensated for gambling and lending they will continue these activities regardless of the solvency of their institution unless the financial regulators intervene with policies like higher capital ratios.
• The balance sheets of Britain's major banks total some £6 trillion. The aggregate of British lending to small and medium sized enterprises is below £200bn. The committee is concerned about that portion of SME lending which seeks and merits credit. It is also concerned about the loss-absorbing buffers needed to support the other £5.8 trillion.Leading up the financial crisis, the structured finance market was a significant source of funds for the SMEs. The structured finance market is a fraction of its former size. This is a direct result of current disclosure practices that do not provide investors with the timely performance information on the underlying collateral that they need to know what they own.
Investors prefer not to blindly bet and instead are investing in asset classes that provide transparency.
To attract investors back to structured finance and reinvigorate SME lending will require that each security provide observable event based reporting. Under observable event based reporting, every activity, like a payment or default, that occurs with the underlying collateral is reported to all market participants before the beginning of the next business day.
With current information, investors can know what they own and prospective buyers can independently assess the value of the security.
• There is a difference between capital levels and capital ratios. Higher capital levels absorb loss, inspire confidence and support lending. By contrast capital ratios can be "improved" by reducing lending without increasing capital.There is a difference between bank capital that is used to protect the real economy from the excesses in the financial system and bank book capital levels that are meaningless.
Bank book capital levels that are used to protect the real economy vary over time. In times when there are excesses in the financial system, bank book capital levels decline dramatically as the losses on the excesses are absorb today. If the losses are large enough, bank book capital levels can become negative.
Bank book capital levels that are meaningless tend to increase during a financial crisis. This increase is a sure sign that the losses on the excesses in the financial system are being shifted onto the real economy and that there is a financial regulator induced credit crunch.
• Capital is not something locked away in the vault. An incremental pound of capital can fund an incremental pound of loans. And given current bank leverage, each £1 of additional capital can support £20 of additional small business lending – provided, of course, that the liquidity funding is available. Alternatively, some portion of incremental equity could support new lending with the remainder used to build buffers and reduce leverage.Of course, once again this focus on capital is irrelevant as it implies a link between lending and capital that does not exist.
What is well known to everyone except perhaps the FPC is that banks make loans when the opportunity arises and then look for how to fund the loans.
While many people think that structured finance was the original originate to distribute banking model, it wasn't.
For decades before structured finance became significant in size, banks would sell participations in their loans or the whole loans themselves to other banks, insurance companies and pension funds. This was a classic way for smaller banks to diversify their loan portfolio by geography and industry. It also resulted in matching loans to deposit funding already in the system.
• Allowing capital ratios to fall might lead to new real economy lending – but it might not. It might merely fuel intra-financial risk-taking with little positive impact on small business requests.
• And even if lower ratios did lead to new business lending, to which businesses would the loans go: to a manufacturer in Manchester or a shoe factory in Shenzen?....Of all the financial regulators, the FPC should know that it is not the job of regulators to approve or disapprove of individual positions taken by banks. Doing so explicitly substitutes the regulators for the market in the allocation of capital.
Recently the Chancellor announced that the committee would add an economic growth objective to that of stability.How disappointing as it would have been far better for the UK and global financial stability if the Chancellor had put the FPC out of existence so that it could do no further harm to the real economy.