Thursday, September 27, 2012

Bank of England's Robert Jenkins: A debate framed by fallacies

In a must read speech, Bank of England Financial Policy Committee member Robert Jenkins looks at how the financial industry framed the debate on regulation after the financial crisis on three myths.

Specifically, the myths were

we must choose between safety and growth. The banking lobby would have us believe that higher capital requirements and lower leverage will damage economic growth and retard the recovery. “Increase our capital requirements and we will reduce our lending!”... 
To the exposure of myth number one, bankers retort: “How dumb can you be?” “Equity is expensive. Make us double our equity and you will lower our Return on Equity, damage shareholder value and discourage the supply of bank capital.” Here we have myth number two.... 
The third myth follows from the second – to wit: governments must choose between domestic financial stability and the competitiveness of their domestic financial centers. Clearly, if you believe that higher capital requirements damage bank profitability and shareholder returns then you must also fear for the competitiveness of your domestic banking champions, the attractiveness of your country as a global finanz platz and the tax take for your treasury. 
Let me go on record as saying that I agree with Mr. Jenkins that each of these is a myth.

However, the first two of these myths obscure a more important myth.  The myth that the level of the accounting construct known as the bank capital is important in a modern banking system.

Regular readers know that in a modern banking system, banks are designed to protect the real economy by absorbing the losses on the excess debt in the financial system and still continue operating.  They can continue operating because of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers become the silent 'equity' partner for any bank with low or negative book capital levels as a result of absorbing the losses.  With taxpayers as a silent 'equity' partner, there is no reason to bail out a bank that is capable of generating earnings and rebuilding its book capital.  As for the banks that cannot generate earnings, they need to be closed.

All three of Mr. Jenkins myths obscure a second important myth.  The myth that the level of the accounting construct known as bank capital is synonymous with financial stability.

Regular readers know that financial stability is a function of transparency.

Financial systems that are characterized by complex regulations and regulatory oversight as a substitute for transparency are prone to crash.  Our ongoing financial crisis demonstrates this on a daily basis.

Financial systems that are characterized by transparency are not only stable, but have a competitive advantage.  How many times have you heard that investors are drawn to the US financial markets because they are the most transparent?

Regular readers know that I have advocated bringing transparency to all the opaque corners of the financial system.

For banks, this means requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

For structured finance securities, this means that all activities like a payment or default involving the underlying collateral are reported on an observable event basis before the next business day to all market participants.

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