To Make Banks Strong, Do Away with the Regulator

As the UK economy enters the COVID-19 downturn, the Bank of England (BoE) continues to maintain that the UK banks are strongly capitalised. The BoE’s claims are not to be believed.

As ex-Prudential Regulation Authority (PRA) regulator Dean Buckner and I set out in our new report on the state of the UK banking system, the core metrics of the Big Five UK banks have deteriorated sharply since the New Year and even more since the end of 2006, i.e. since the eve of the Global Financial Crisis (GFC). As of 1 May, their market capitalisation was a mere £148.5 billion, down 57% since December 2006; their average price-to-book ratio was 42.7%, down from 255% at end 2006; their average capital ratio, defined as market capitalisation divided by total assets, was 2.7%, down from 11.2% at end 2006; their corresponding leverage levels are 36.7, up from 8.9 at end 2006. By these metrics, UK banks have much lower capital ratios and are more than four times more leveraged than they were going into the previous crisis.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their price-to-book ratios would be well above 100% reflecting the values of (a) the banks’ assets, (b) the banks’ future profitability, or franchise value, and (c) the shareholders’ limited liability put option. Their capital ratios should be well above current levels too. Traditional rules of thumb also suggest that leverage levels should be much lower too. And didn’t everyone say that excessive leverage was a major factor intensifying the severity of the last crisis? Er, yes.

This state of affairs might come as a shock to those accustomed to listening to the BoE’s balmy (or should I say, barmy) “Great Capital Rebuild” narrative that the UK banking system is now super strong. The Great Capital Rebuild is little more than a lovingly wrought window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The BoE also made the mistake of focussing on regulatory capital measures instead of market-value capital measures and on the highly gameable “Risk-Weighted Assets” measure that its own chief economist has shown to be discredited. The Bank then arrived at entirely the wrong conclusions.

The result is that the UK banking system enters this downturn in a fragile state that makes another round of large bank bailouts inevitable, and this despite the BoE having had over a decade to ensure that the banking system was returned to financial health. We have here an appalling failure of prudential regulation.

The underlying political economy is simple enough. Central banks and financial regulators adopt policies such as lender of last resort and deposit insurance that encourage bankers to over leverage their banks in the expectation, largely correct, that the authorities wouldn’t dare let them fail in a crisis. The authorities then use capital adequacy regulation to try to constrain excessive bank leverage, but that doesn’t work.

As just one illustration of how badly it performed the last time, for every pound of remuneration received by the bankers for taking excessive risks, the banks suffered about £10 in losses and the economy experienced GDP losses of around £100, and maybe more.

So huge damage was inflicted on the economy so that bankers could extract relatively small rents from it, and it is happening again, now. The bankers have become the new trade unions and the regulator, whose job it is to rein them in, is moonlighting as their chief shop steward.

Between them, they have wrecked UK banks’ capital adequacy, which is one of the cornerstones of our economic system. We need a new Mrs T to sort them all out.

One might ask what that would entail. The central issue here is not the bankers’ wish to take excessive risks so that they can enjoy enhanced profits in the good times and be bailed out in the bad, at ever growing cost to society at large. The central issue is that the regulator repeatedly allows them to get away with this game because the regulator is captured by the banks. The regulator itself is the enabling mechanism that maintains the Bankster Social Contract.

No amount of further regulatory reform – no Basels IV, V or VI, no rearrangements of the regulatory deckchairs and no lick of fresh paint – will make any difference. The regulatory agency, which exists to ensure that financial institutions are strong, produces the opposite result to its stated purpose, because the bankers want it so and the bankers call the shots. Thus, the regulator will always fail to achieve that purpose, because it can do nothing else. We can’t reform it. We can only get rid of it. We have to get rid of it.

My proposal is that the UK should: pull out of the Basel regulatory capital system; extend personal liability for senior bankers; raise minimum required capital to, say, 20% of market capitalisation to total assets; enforce that minimum by banning dividends, bonuses and buybacks until that minimum is met; allow banks a “regulatory offramp” which exempts them from prudential regulation provided they meet the new minimum capital requirement; and put the PRA into runoff mode with a sunset of no more than ten years. As the sunset approaches, the PRA puts any banks remaining under its care into bankruptcy and then disappears into the sunset too.

The end result would be a strong banking system and no more regulator.

Republished from Institute of Economic Affairs

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