Guest Post: Not far enough – Recommendations of the UK’s Independent Commission on Banking

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By Charles A.E. Goodhart and Avinash Persaud. Cross posted from VoxEU

The UK’s Independent Commission on Banking was set up last year to consider reforms to promote financial stability and competition. This column reacts to the commission’s interim report released on 11 May 2011. It argues that the commissioners have a lot to ponder before the final report is due in September – they have not gone far enough.

Despite the intellectual firepower of the UK’s Independent Commission on Banking, the reforms proposed in the interim report will not make the UK financial system any safer. The commissioners’ intentions were waylaid by the absence of an analytical framework of financial stability or, what might have sufficed, a rigorous analysis of what actually went wrong. The political imperative to be seen slapping banks for their misdeeds – though not so hard as to undermine them – would also have been distracting.

At the centre of the financial crisis was a nexus of excessive leverage and an unsustainable expansion in housing markets, accelerated by the use of risk-weighted assets as the basis of capital, liquidity, and accounting ratios. This has been set out before in a number of reports (see for example Brunnermeier et al. 2009). To make matters worse, political pressures led the risk weights for housing lending and all Eurozone government bonds to be fixed at artificially low levels. Proposals for constraining property bubbles financed by excessive leverage should therefore be central to this report. But they receive scant attention, muscled out of the way by a focus on increasing competition, ring-fencing retail from wholesale banking and introducing instruments to bail in creditors. These are solutions to a different set of problems than financial instability.

The financial crisis had little to do with the structure of banking. Where unsustainable housing and property finance was provided by pure retail banks like Northern Rock and the Irish banks, they were the weak points. When provided by investment banks like Lehman Bros and Bear Sterns, or by universal banks like UBS and RBS, or even quasi-government agencies like America’s “Fannie” and “Freddie”, they too were the weak points. Moreover, the notion that we can limit the exposure of taxpayers to the financial system by saving the retail part of the banks and letting the wholesale part go to the wolves seems, stunningly, to ignore the example of the failure of Lehman Bros, a modestly sized wholesale bank, whose failure seized up the whole banking system. In the credit economy confidence is everything and is not easily divisible. Waterproofing individual compartments did not save the Titanic from a sinking either. In hindsight, saving Lehman Bros might have been the cheaper route for taxpayers. It would have been cheaper still if Lehman’s leverage were limited more effectively than the risk-weighted capital ratios the report keeps faith with.

The report promotes “challenger” banks to prise open a cosy banking oligopoly. But it was precisely those “challenger” banks like Northern Rock, HBOS, and Anglo Irish that introduced ‘dodgy products” and took most risks to build market share. Recall Northern Rock’s “Together” 125% loan-to-value mortgages. The Icelandic banks were archetypical challengers; “Icesave” offered better returns to depositors. Their success leads normally more prudent, incumbent banks, to emulate them. The main purpose of US regulatory laws after 1933 was to reduce competition in the name of stability. There is a long-standing tension between competition and stability and the report does not tell us how to solve it.

The Commission flirts with bail-ins and co-co bonds. These are clever products that make their protagonists seem cleverer still, but they will lead to an even quicker and more complete shutdown of the credit markets were we once more to be in the breach of systemic failure, where asset prices have dropped out of the sky, and as a result, every bank is about to bail in their creditors – who are invariably also taxpayers and pensioners. These instruments are better suited to the failure of a single bank. But we are reasonably good at managing single-bank failures without them – as evidenced by the contained failures of JMB, BCCI and Barings.

Without a framework of systemic risk control it is easy to think that the solution to protecting tax payers lies in saving “Captain Mainwaring” style domestic retail banking from “Gordon Gekko” style international investment banking. But systemic risks are caused by a previous, collective, underestimation of risk by the Mainwarings and Gekkos and all others in between that promote excessive lending and leverage. It follows from this that the way to make our financial system safe is to make it less vulnerable to the mispricing of risk and pro-cyclical valuation. There are two ways to do this:

First, by limiting leverage in ways that are divorced from perceptions of risk. A simple leverage ratio (assets to equity) and counter-cyclical loan-to-value ratios for housing should be key components.

Second, we need to increase the capacity of the financial system to absorb risks for a given amount of leverage. This requires common capital adequacy requirements across the financial system that incentivise transfers of credit and liquidity risks so that when risks do blow up, credit risks in the system as a whole are diversified and maturity mismatches (liquidity risk) are minimised.

The report’s main recommendations – slightly higher risk-weighted capital ratios, more competition, and ring fencing retail from wholesale banking – do not do either of the above.

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  1. F. Beard

    At the centre of the financial crisis was a nexus of excessive leverage … Yves Smith

    Some have recommended that all bank leverage be abolished. Banks would simply lend money that was deposited with them for that purpose and nothing else. Some question how this could be enforced.

    Others merely recommend that all government privilege for bank leverage be eliminated so that free market competition would limit it. I read somewhere that without a central bank that banks are limited to about 2 to 1 leverage.

    Others go farther and recommend that genuine private currencies be allowed to coexist with the government’s money supply. Government money would only be legal tender for government debts, taxes and fees, and private monies would only be acceptable for private debts. Free market exchange rates would prevail between the government’s fiat and private money supplies.

  2. joebhed

    Not much ‘prodding’ in this analysis.

    Taking the “that ain’t it” approach here deprives the readers of what “it” is, that “it” being the comprehensive financial service reforms needed to secure stability in the debt-industry.

    Why not say which of the commission’s menu of items it looked at, and received comment on, are actually the important ones from a ‘stability’ view, and then say why?

    You have the floor. Taking pot-shots at these weak recommendations does not take us to what really needs to be done.

    Where is the discussion of ending speculative finance with faux-money leverage, not just ring-fencing this “banking” operation?

    Where is the discussion of full-reserve based narrow banking of the Mervyn King proposals to the monetary policy committee and the Buttonwood gathered?

    Again, what we need is to say what is required to achieve financial stability, and why.


    1. F. Beard

      Again, what we need is to say what is required to achieve financial stability, and why. joebhed

      I’d bet that “financial stability” is not stable itself. Why? Because it could easily conflict with financial liberty and prosperity.

      Instead we should be concerned with an ethical money system which would almost certainly be stable too overall while not sacrificing growth potential.

      1. skippy

        What makes you think_any one_ would transport themselves back 2.000ish years..really…you and all dialogs have a cult basis. Growth is the tool of empires, yours had a chance, give it up.

        Skippy…maybe you could opine about manifest destiny, with a spear up your back side. To whit religion of any strip is hierarchy based on nonsensical belief, a world stripped in its name, it does not matter what form of exchange we have if it’s based of truthfulness (lies of your betters).

        Ps. your one book has missed almost every thing that has transpired…save the general waxing anyone could have submitted by looking back.

        1. F. Beard

          it does not matter what form of exchange we have if it’s based of truthfulness (lies of your betters). skippy

          Not quite. Government is force so its money is backed by force. The private sector is supposedly voluntary exchange so why is a forced based money legal tender for private debts?

          1. ambrit

            Dear Beard;
            The “force” behind most daily transactions on the ‘Main Street’ level I will propose is simple daily survival. Since few of us still live at the hunter gatherer level, mediums of exchange, (money,) are necessary for society to function. I would suggest that private money systems are a step backward. Remember the scene in the Bergman film where the settler, after returning to his home with the “money” from the independant Bank out on the Prairie discovers that he can’t redeem it anywhere but at that bank? Such a two tier system as you suggest would not double, but quadruple the chances of chicanery. The purpose of the governments establishment of a “fiat” money system is stability. What you do with that is another matter.

          2. F. Beard

            Such a two tier system as you suggest would not double, but quadruple the chances of chicanery. The purpose of the governments establishment of a “fiat” money system is stability. ambrit

            People would always be free to use the government’s fiat for all debts not just government ones. However, the existence of genuine alternatives to the government’s money would keep it honest.

            What you do with that is another matter. ambrit

            That’s another reason to allow genuine private currencies – to escape the extortion of the banking system for government bailouts. Our government enforced monopoly money system is a single failure point in the economy and the bankers exploit that fact.

  3. Susan Truxes

    Excessive leverage is the canary in the coal mine. We need more money out there. I didn’t understand one word of this article, I just lifted phrases. I mean: how do they qualify Lehman’s collapse as the downfall of a “modestly-sized wholesale bank?” It was a 9.5 mega collapse. It would have been a 10 point disaster if the bunnies hadn’t scrambelled to plug the holes. What BS. Here’s how we must seek to communicate in all future analysis: First: Start with the Subject; keep it isolated; next: Second: move on to the verb: keep it isolated; and Third go on to the object, and also keep it isolated. Etc. Syntax will always trump fairy-dust accounting and doublespeak. And while we are striving to communicate let us not twist what happened with BCCI (Jesus) and Barings. Please.

  4. Ottawan

    Brits truly are superior writers, I swear. But by and large, they’re about as dumb as the rest of us. Which is a good segue:

    Think your average Brit will even know of the report, let alone peruse it?

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