BBC's Robert Preston searches for how to restrain bank risk taking

In a terrific column, the BBC's Robert Preston examines how both bank regulators and Basel capital requirements failed in the run-up to the financial crisis and asks what can be done to restrain bank risk taking.  Mr. Preston proposes a cap on bank leverage as a solution.

Regular readers know that the only way to restrain bank risk taking is to subject the banks to market discipline by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is not the size of the bank nor the leverage that it has, but the riskiness of all of its exposures that needs to be restrained.

Leverage is the ratio between what banks lend and invest on the one hand and the capital they hold to absorb potential losses on their loans and investments. 

So all else being equal, which they never are of course, a bank with a lower leverage ratio is a safer bank, because it has relatively more capital to protect depositors from losses.

But that doesn't necessarily mean that you should always place your precious savings in the bank with the lowest leverage ratio: the bank with the low ratio might be lending and investing in a particularly reckless and risky way; although it might have more capital than other banks, its losses might turn out to be massively bigger than those other banks. 

That's why a low leverage ratio is not a guarantee that a bank is safe..... 

Please re-read the highlighted text as Mr. Preston makes a very important point that a bank's leverage ratio is not necessarily a good indicator of how much or little risk it has.

Dexia confirms this.  Dexia had one of the lowest leverage ratios as measured by the Basel capital requirements in the EU shortly before it was nationalized.

Here are the important points: riskier loans and investments provide bigger rewards to banks, until the loans and investments go bad; and capital is expensive for banks. 

Which is why governments did not trust banks to behave prudently if they were subject to a simple gross leverage restriction. 

The assumption was that if every bank was told it could not lend - for example - more than 20 times its capital, large numbers of those banks would lend everything they could to reckless gamblers prepared to pay the highest interest rates, till gamblers and banks went bust. 

Instead governments hired regulators to check that banks were not taking insane risks. And the regulators invented the Basel system of risk-weighted capital ratios, which stipulates different leverage ratios for different categories of loan, in theory to take account of the riskiness of those loans. 

To put it another way, governments set up a system that in effect treated bankers as naughty children or ravenous puppies who could not be trusted not to eat too much of the dangerously fattening stuff - and regulators were to be the health conscious parents. 

The perhaps predictable result is that the bankers lived up to the low expectations of their common sense, and devised ever more clever ways to raid the biscuit tin without being seen. And the regulators turned out to be the worst kind of parents: ignorant of what was really happening in the world; prescriptive in all the wrong ways....

In the many hundreds of pages of Basel rules in their assorted iterations since the 1980s, each bank became an amalgam of hundreds of different leverage ratios, reflecting the perceived riskiness of the different categories of the loans it made and indeed of the age and size of the bank....

With good intentions on the road to ruin, regulators through the Basel rules were trying to provide a framework in which the risks and rewards of lending were properly captured. 

In practice they did precisely the opposite: the Basel system provided the following arguably insane incentives: 

1) banks had incentives to become bigger and bigger, to benefit from "advance" status that rewarded them with relatively lower capital requirements; 

2) banks had a disincentive to know their corporate and personal customers, but instead had an incentive to insist that each loan was a mortgage backed by property - thus encouraging a dangerous boom in property lending; 

3) banks had an incentive to become huge in trading loans and investments; 

4) banks had incentives to convert risky loans into opaque AAA bonds that appeared - spuriously - to be safe. 

In other words, regulation in the form of the Basel rules contributed directly to so much that is wrong with today's banks....

Please re-read the highlighted text as Mr. Preston has nicely summarized why when it comes to restraining bank risk taking the combination of complex rules and regulatory oversight doesn't work.

Besides, all of the Basel capital requirements have been designed to provide opacity so that banks can increase their leverage and their return on book equity.

And the big banks could stick to the letter of the Basel rules and appear to be sound, when in fact they were massive, fiendishly complex and impenetrable institutions taking insane risks....

Please re-read the highlighted text as Mr. Preston makes the case for why banks should be subjected to market discipline and required to provide ultra transparency.

With ultra transparency, banks cannot hide behind the facade of appearing sound under either the complex Basel capital requirements or leverage ratios.

With ultra transparency, banks are no longer impenetrable institutions and their complexity and risks are exposed.

Now the 2008 Crash made it impossible any longer to pretend that the system of keeping banks on the straight and narrow was working. 

But government's response has been a bit skewed and odd. 

On the one hand, the collapse of the financial system has been taken as proof that bankers are incorrigibly, irredeemably naughty children. 

By contrast, there is a presumption that the regulators who got it so wrong - the useless parents - can be redeemed.

Who can forget former Treasury Secretary Tim Geithner assuring us that the regulators had learned their lesson from the 2008 Crash?

Actually, the response of the regulators and policymakers was predictable because they are simply continuing with their existing policy of financial failure containment and its corollary, the Geithner Doctrine.

One consequence is that the Basel rules that were so hopelessly flawed have been redrafted, and in the process have become even more complicated and impenetrable. 

And regulators have been given more powers to interfere in banks, to supervise them, and deter them from misbehaving. 

Some might say that the banks have been punished, and the regulators - who arguably were just as much at fault - have been rewarded.....

Actually, neither the banks or the regulators have ever been punished.

Which brings us back to where we started, the bloomin' gross leverage ratio. And it is to ask the question whether the global financial system, and the economies of developed countries like Britain, would be in such dire straights if banks had been subject to a simple leverage ceiling, limiting how much banks could lend in total, irrespective of the nature of their loans, as a multiple of their capital....

It brings us back to the issue of how to restrain bank risk taking as Mr. Preston has already acknowledge that a bank with a low leverage ratio can be carrying substantially more risk and incur far greater losses than a bank with a higher leverage ration and lower risk profile.

All that said, some might argue that this important debate still misses the big point. Because any leverage ratio is being seen - in Basel and Westminster - as a backstop, or only a bit of background insurance in case the Basel rules prove inadequate yet again. 

There is no serious discussion of the idea that a low leverage ratio should be the first line of defence, and that the Basel risk-weighting rules should be less prescriptive and more in the form of guidance....

The entire discussion needs to be taken off of leverage ratios or Basel risk-weighting rules.

The discussion needs to be focused on requiring the banks to provide ultra transparency and disclose on an ongoing basis their exposure details.  It is the exposure details that reveal the risk a bank is taking.

Ultimately, it is the amount of risk that a bank takes that needs to be restrained.  And the best way to limit bank risk taking is to have the investors who are first in line for absorbing any losses exerting discipline to restrain bank risk taking.

All of which is perhaps to point out that the terms of the debate about how to sanitise the bloated financial system have been set by a regulatory community whose legitimacy should perhaps have been destroyed but which still seems (amazingly?) to be in loco parentis.

Please re-read the highlighted text as Mr. Preston confirms Jeff Connaughton's observation about why Wall Street always wins.  The Blob (aka, policymakers, regulators and Wall Street's lobbyists) set the terms of the debate.

Do you think it is by accident that transparency is not in the discussion by regulators and policymakers as a means for restraining bank risk taking?