Capital and liquidity: whose problem?

By Richard Smith, surfacing briefly again.

Jon Daniellsson of the LSE has spotted something odd about the Basel III debate on capital levels:

In the ongoing debate on Basel III, one of the most contentious issues has been the level of bank capital. One might think that the countries making the biggest public noises about problems of excessive risk-taking and speculation would be exactly those demanding higher capital. After all, higher capital directly reduces leverage and risk taking, increasing safety.

Surprisingly, it is the opposite.

  • The main champions for more capital are the US, UK and Switzerland,
  • The opposition is led by Germany and France.

And he speculates darkly about the reasons why the French and Germans oppose giving national regulators discretion to impose higher capital levels than the new Basel III minimum (7% of RWAs):

Perhaps, the real reason for the French and German opposition to variable capital standards can both be found in weaknesses in those countries’ bank assets and their willingness to use taxpayers’ money to bail out the banks.

Could be, but one would like some evidence. Besides, the other link between the US, UK and Switzerland is that they all recently engaged in really massive banking bailouts, and may not feel like repeating the exercise for a while, thank you.

There’s something else though, that might better support Danielsson’s claim. In parallel with the debate on Basel III capital levels, we have plenty of chatter about the effect of a Greek default on the financial system. The bosses of the big banks are saying it could be pretty nasty; here’s Ackermann of Deutsche Bank:

Josef Ackermann cautioned against any steps that could spread the crisis to other vulnerable countries in the 12-year old currency bloc.

“If it is Greece alone, that’s already big. But if other countries are drawn in through contagion, it could be bigger than Lehman,” the Deutsche Bank chief said at a Reuters banking event on Monday.

And here’s Ghizzoni, CEO of Unicredit:

If, after a year of discussion without conclusion, we conclude there will be a haircut, the next morning the market will massacre Ireland, Portugal and maybe other countries.

So would a Greek default be another Lehman, or bigger, or a “massacre”? We are going to find out eventually, and for what it’s worth there is a robust challenge to the doom-mongering in today’s Guardian, though I am surprised its writer thinks there was no warning of the Lehman collapse. He should have been reading “Naked Capitalism”. Certainly, though,  no-one did much to prepare for Lehman’s very foreseeable implosion; in which respect it does resemble Greece somewhat.

Perhaps the real point of these utterances is in fact to start getting ready for a Greek default, or default-like event, or whatever it will be. From a bank exec’s point of view there’d be no harm in a spot of proactive corraling of the politicians, who have much more say in bank capital and liquidity levels, especially in a crisis, than the Basel committee. For an indication of progress on the corraling, refer to Merkel:

Merkel said June 18 in Berlin that policy makers must make sure the Greek crisis doesn’t infect the rest of the euro region and spark a new global financial crisis.

“We all lived through Lehman Brothers,” she told a meeting of activists from her ruling Christian Democrat party. “I don’t want another such threat to emanate from Europe. We wouldn’t be able to control an insolvency.”

Frau Dr Merkel is well and truly onside with the banks, I would say, even down to this irritating “Greece is another Lehman” meme (shade of last year’s interminable “Country X is not Country Y” burblings from all and sundry).

The message that’s coming through loud, clear and confident from these media statements, and from the Eurolobbying against the Basel III rules, is this: bank capital and liquidity are not going to be problems for the banks. Instead, the politicians will fix it, which is to say, some angry taxpayers, somewhere, will fix it.

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16 comments

  1. Phichibe

    Hi,

    Great article. This gives me the opportunity ask NK for your take on Bethany McLean’s article in Slate on bank capital requirements and whether these really get to the heart of the matter or if it’s a question of liquidity/quality of the assets. Any thoughts from Richard or Yves would be most welcome.

    I hesitate to dismiss McLean’s objections given her acuity in previous episodes of financial malfeasance, notably Enron. However, if she’s correct then it seems to me that we may be focusing on the wrong problem. Thoughts?

    Thanks,

    Phichibe

    1. RueTheDay

      This is not an either/or situation. All three (capital, liquidity, asset quality) are important. Capital is the inverse of leverage and is the buffer that determines how much of an asset price decline a leveraged firm can withstand before becoming technically insolvent. Asset quality and transparency determine, respectively, how likely such an event is and how quickly and accurately the market can assess such a situation. Liquidity affects both assets and liabilities – how easily can I rollover my liabilities and how easily can I sell assets at a decent price should I unexpectedly have to do so. Effective regulation must address all three components. If I’m a highly levered institution funding long-term, illiquid, opaque assets with short-term liabilities in an illiquid funding market that can dry up overnight, I’m a disaster waiting to happen.

  2. Richard

    Phichibe,

    Capital is the wrong focus. As Bethany points out, the right focus is asset-level transparency. With this disclosure, everyone would know which banks are exposed, how much they are exposed and whether the exposure could make them insolvent or not.

    The lack of this disclosure can only be blamed on the regulators who belatedly are calling for it.

    1. RebelEconomist

      I agree that rigorous valuation of assets is important, and I am wary ( http://reservedplace.blogspot.com/2008/08/its-wind-up.html ) of the arguments against the procyclicality of mark to market accounting. However, I was convinced by a banker I know (yes, awful isn’t it!) that there is a case for making an allowance for liability liquidity too. It ought to be possible to take account of the value of locked-in funding, which effectively increases massively in a crisis.

      1. Nathanael

        The correct accounting was worked out a long time ago: lesser of cost or market for assets, and correspondingly, full contracted payment value for liabilities.

        That’s what’s known as conservative accounting.

    2. Richard Smith

      I think both the assets and the liabilities need to be disclosed and valued better before capital requirements stand a chance of making sense, if they ever will. That is pretty much the other Richard’s position I think (but my apologies to him if I am distorting).

      On the funding model side, I am with RE: deposit based funding is relatively robust (as long as people think their banks is solvent…), whereas market based funding seems to be able to vanish from one day to the next. You’d think that investors in bank equities would care about that, but I suppose if the lender of last resort is cheap enough, there’s no reason to be so picky.

      It would be nice if there was some penalty (market or regulatory, I don’t much mind which, at the moment) for balance sheets that hold relatively more contingent liabilities, assets valued by models, and funding models that depend heavily on as it were contingent funding.

      But we now have a lot of credit that depends on these fragile structures, so getting rid of them would require some extra contraction in credit, or a very cunning plan indeed, which I don’t think anyone is working on.

      1. RebelEconomist

        Actually, in some ways, market-based funding is more sticky, because it tends to be contracted for some time, like a month or so in the case of CDs. But much depends on the courage of the authorities – if they readily decree bank failure, they can bail in the wholesale market creditors, but run the risk of being blamed for raising alarm and destroying a viable concern. It seems to me that bank resolution is key, and we do not seem to have sorted that out yet.

    3. Jason Rines

      Bravo Richard. One of the most powerful opinions Yves ever formulated was on mark-to-market and price discovery. Without it, no confidence and shrinking markets.

      The second major issue is now ZIRP and in general Central Banking encouraging bubbles which further skews asset prices sending artificial signals and creating malinvestment on a planetary scale.

      “Give me a control of a nations currency and I care not who makes the laws.” – Rothchild

      The flaw is in Central Banking which purposely exacerbates our struggling human evolution of the boom/bust cycle.

      Bankers make loans, they don’t run fiscal policy. They won the world through leverage and now we all get to watch it collapse, because they won’t manage themselves back to a virtuous cycle. This is the real reason there is no way out without bloodshed and why those that own this franchise are culpable.

      Two decades of the leverage game, malinvestments and no sustainability/fiscal policy. Now the world’s wealth is centralized. Half have enough, the rest do not. Hmmm, not hard to figure out this one on what will happen. For those guessing, the violence to restore individual and national sovereignty is going to be epic. Get involved at the local level if your tired of struggling for decades. I have to respect the Bill Black’s, Elizabeth Warren’s, Yves Smith’s, etc. for there passion for our well-being.

  3. Sundog

    Being an advocate of narrow banking, I’d prefer the issue be re-framed in terms of institutions rather than assets.

    The current legal framework permits “persons” too big to manage to yet not too big to influence policy.

  4. antin

    As far as I remember there is a particular problem with German banks, that they usually have some form of bank capital that is not counted to the bank capital in Basel regulations, but is in fact bank capital. That is why Basel capital regulations tend to disfavour German banks and so Ms Merkel disagrees.

    1. RebelEconomist

      You are right; I did think that Danielsson’s VoxEU article was a bit lightweight. I presume you refer to the so-called “silent participations” in German banks like the Landesbanks, often by the Lander governments. These may not absorb losses on a “going concern” basis, but they do mitigate losses to more senior creditors such as depositors in the event of a bank failure, so I guess the Germans have a point. Dunno about the French though; in my view they are always up to no good!

    2. Richard Smith

      The “stille Einlagen” are something like silent partnerships, but translated to the world of equity companies. Anyhow the effect is that the bank comes pre-bailed out, to some degree; the contingent liability sits with the holder of the “stille Einlage”. So they had better be happy with the return they get in the good times. It’s an insurance proposition, with a remarkably passive underwriter. Not so different from the taxpayer bailout mechanism, in extremis, but with a slightly different structure.

      The “stille Einlage” is intended to be phased out by 2019 under Basel III (converted to ordinary equity, I assume), which is indeed causing some grumbling in Germany.

  5. Linus Huber

    The buck ends here. Until now the politicians got away to transfer the problem of the financial sector to the public. In a democracy the wheels of justice work very slow especially when it concerns aspect of an industry with such great lobby cloud but nothing lasts forever. It is the voter who will say the buck ends here and the coming elections may produce leaders who will correct the system of theft from the tax payer to the speculator (meaning here mainly the too big to fail banks). It is just that slow in the coming that drives me crazy.

  6. Ransome

    When you share a common currency and you allow cross border banking you are selling the euro back and forth trying to get rich. It ties economies together in an unhealthy way and undermines the euro. This is using gold strategies of control in a spreadsheet banking world. To get rich, with a common currency, means increasing debt and debt service, preferably outside of your home nation so you don’t wreck it directly. It is lending to those that can barely afford it and charging high rates of interest. The money center banks become too interconnected to fail. The politicians end up working for the banks because they don’t want their home bank economies to fail, while they beggar the economy next door and undermine the euro. To correct the problem, you need narrow form banking in its narrowest forms.

    If you watch the Machines of Loving Grace video, having a giant computing machine with infinite formulaic feedback loops run by a few men can create chaos on a macro scale (war, food shortages, banking crises) while individuals working rationally for their self interest creates chaos on a micro scale (anarchy). Whereas the body begins with a master plan and then specializes into discrete organs and cells, each responding to specialized feedback. Many things get injured, get repaired, get injured and get repaired before the body finally decompensates. The more complicated the organization, the more reliant you become on redundant specialization with feedback.

    Ten thousand specialized and regulated small banks lending locally are safer because of diversity than ten large money center banks controlled by 20 men lending to the world, because their range of experience is infinitesimally narrow, which is not so much the problem because they simply don’t care about anybody but themselves and their big computer. When accused they say we did nothing wrong, we respond you did nothing right.

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