Saturday, November 24, 2012

King vs Osborne: a tussle over meaningless bank capital requirements

Against the backdrop of EU banks asking for a one year delay in the introduction of Basel III in light of the US not implementing Basel III in 2013, we have the spectacle of the Bank of England's Mervyn King fighting with UK Chancellor George Osborne over leverage on UK bank balance sheets.

Regular readers know that bank capital and any ratio involving bank capital is meaningless.

The OECD observed that bank capital is meaningless given the existence of regulatory forbearance that allows banks to engage in 'extend and pretend' with bad debt and the suspension of mark-to-market accounting.  Both directly manipulate bank book capital levels by overstating exactly how much book capital there is.

Capital ratios are an example of the combination of complex rules/regulations and regulatory oversight that are substituted for transparency and market discipline.

The financial crisis showed that this substitution contributes to financial instability and makes the financial system prone to failure.

Regular readers know that what is needed is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently assess the risk of each bank and calculate capital ratios if they want to as part of this assessment.
Indeed, the more important clash is King v Osborne on the vital issue of the degree of leverage on UK banks' balance sheets. 
Vickers' panel was crystal clear: leverage should be capped at 25 times capital. But the chancellor has watered down that proposal, saying the government is happy to tolerate 33 times. 
To most outsiders, it looks as if Osborne has been swayed by the lobbying of the likes of Santander UK, which argues that a mortgage-dominated bank would be constricted by Vickers' harder limits. 
Of course the government is swayed by the lobbying of the industry.  There is no surprise here.

What is left unsaid is that both King and Osborne are swayed by the lobbying.  In particular, both of them are spending time arguing about a meaningless capital ratio when what is needed is to restore transparency to the banking system.
Vickers was unhappy about the watering-down and King sounds furious. 
The governor gave a blistering defence of the more conservative approach. International standards for calculating risk-weighted assets are too inflexible; risk weights move over time; and in major crises risks tend to interact. For those reasons, pure leverage ratios have proved the best guide to the strength of a bank in a crisis. 
As King pointed out, Northern Rock, while fully up-to-date with the Basel banking committee's finely tuned risk calculations, was still operating at 80 times leverage before its collapse. 
The argument over the right amount of leverage is nonsense.

The only relevant issue is how much risk the banks are taking so that market participants can adjust their exposure to each bank based on the risk of each bank and the market participant's capacity to absorb losses given this risk.
Setting sensible leverage ratios should therefore be at the top of the reform agenda. It's more important than the detail of which activities should lie, or be required to lie, within a ring-fenced bank.
Actually, what should be at the top of the reform agenda is requiring transparency.
If King, Vickers (and Tucker?) think 25 times is high enough and that Osborne is being too racy, that's a major concern. Let's hope the commission, which seems to be in a mischievous mood, kicks up a storm about leverage.
I am hoping the commission kicks up a storm about transparency which is what truly matters and is the only sensible reform.

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