Sir John Vickers, Michael Boskin, David Brady, Elizabeth Cobbs, John Cochrane, Paul Gregory, Rick Hanushek, Nick Hope, Dan Kessler, Paul Peterson, Jim Shelley, George Shultz, John Taylor.
Sir John Vickers, Warden of All Souls College, University of Oxford, presented “Banking Reform in the UK.”
(Slides from the event.)
He covered the events in the UK corresponding to the US Dodd-Frank act and its implementation by various agencies. The UK followed a quite different path. (See also the slides posted here.)
Broadly, the reform effort has two foci: 1) Structural, the separation between retail and investment banking and 2) increasing capital buffers.
Vickers opined that the effort to raise equity has stalled, that the effort on reform seems now half-hearted, and beginning a retreat.
(See “relative size of banking sectors”)
The UK faced a somewhat different circumstance than the US. Before the crisis, the size of UK banks relative to GDP was much greater than in the US — 450% of GDP rather than about 100% of GDP for the US. UK banks do much more borrowing abroad, and investing abroad, than in the US. That fact leaves them, and the UK, more exposed to financial trouble coming from abroad, and beyond the UK government’s ability to guarantee, even if it wants to.
The time following the financial crisis has been much worse
(See “big hit to UK economy from the crisis”)
Though unemployment rose and returned to 5%, GDP growth has been even slower than the US, reflecting even worse productivity performance. The UK remains 15% below the prior trend. Government debt doubled from 40 to 80 percent of GDP, and that doesn’t count pensions and healthcare obligations made worse by lower GDP and consequently lower tax revenues. The Eurozone crisis is right next door to the UK. And one cannot ignore the possibility that the recession had political consequences, including Brexit.
(see “Banking reform in Britain”)
The US acted quickly [if rashly -JC] by passing the Dodd Frank act in 2010. The UK first had elections in 2010, and then appointed the Independent commission on bank reform (ICB) June 2 2010, of which Vickers was part. He reported that the commission was truly independent, and that bank reform was much less political partisan or a right-left issue in the UK rather than the US. The commission made recommendations on bank structure, capital, competition. It focused on making recommendations rather than assigning blame, as was much of the focus of the US crisis inquiry commission.
The recommendations are
1) Structural reform. Large banks must “ring fence” their domestic (meaning EU wide, at least pre-Brexit) deposit-taking and lending activities from investment banking and wholesale funding.
2) More capital and other loss absorbing activities.
3) Competition, though we didn’t talk much about this today.
The ring fence allows big complex banks to operate in the UK — a necessity given London’s place in the financial world, but ensures that domestic payments, deposits, and lending activity are not brought down by investment banking losses.
To dramatize the importance of this step, Vickers noted that RBS alone has a balance sheet 1.5 times UK GPD, and Barclays similarly. The bulk of losses in the crisis were overseas, unlike the US case that our own mortgages were at fault. “Main street banking should not be impaired by international exposures.” In discussion, he argued there really is no way to separate and rescue domestic activities from large integrated international banks otherwise.
(see “some economics of separation”)
For the UK, international banking competition is also important. The ring-fence concept allows retail baking to be safer, while applying (only) international standards to global activities, and hopefully letting those fail without imperiling the UK economy and budget.
(see “Ring Fence design”)
The “ring fence” is not Glass-Stegall like total separation. It is a cousin of bank holding companies.
A crucial component is that bank holding companies may not drain domestic banks to prop up their international operations, as happened across holding companies in the US in the financial crisis.
(see “banking reform act 2013”)
The next part of the story is the banking reform act of 2013, which included much of this recommended structure.
It also followed the Summer 2012 Libor scandal, and included elements to improve the culture and standards of banking. Again this was, compared to the US, a quite non-partisan effort. Vickers told a lovely story of being quizzed by the Archbishop of Canterbury on risk weights in Basel 3. It included other features. Insured deposits had not been senior to other debt, and now they are. It included a “bail in regime.” Having passed in 2013, this is now in the rule-making stage.
The banking reform act does not however prescribe equity capital levels. That is now a Bank of England responsibility. Here Vickers sees progress halting or reversing.
(see “is equity costly” slide)
To review, equity is not costly to the economy especially considering the costs of occasional severe crises followed by recessions. “Risky banks need more equity not less”)
(see “public benefit”)
In addition, much of the benefit of more capital is to the financial and economic system. [JC: The benefit of fire extinguishers and sprinklers is not just that your house doesn’t burn down as often, justifying the cost. It is that the whole town doesn’t burn down as often, an externality]
(see “policy on bank capital”)
Yet current capital standards are “woefully inadequate” Basel III only increase capital to 7% of “risk weighted assets” and allows a 33 times leverage backstop. This is the solution, not the cause of the problem! Counting in CoCos and long term debt, the backstop is 44 x leverage against common equity. This is also a regulatory capital accounting number not market. With market values below regulatory values, actual leverage is higher still.
The commission had recommended far greater amounts, 10% capital and 25 x leverage backstop. They would have gone higher but were worried about international competition.
[some discussion followed on whether capital requirements really are an impediment to competition, if MM holds, or whether banks are just whining.]
(see “the BoE’s downward capital policy shift”)
Lately, the bank of England has been drifting even lower, removing the 3% Basel surcharges on large banks.
Some of the thinking of this is that they now believe they can quickly resolve failing banks, so more failures will not be more costly. A guffaw erupted from the audience.
They also believe their supervision is so much better banks won’t get in to trouble with less capital, and that they plan to adopt capital counter-cyclically, lowering capital in bad times to boost lending.
Discussion followed, especially noting that all regulators just raised capital in bad times, and that safety on average is not safety all the time. [My version, having two parachutes on every other flight is not as good as one parachute all the time.]
(see “the question of the systemic risk buffer” slide)
Vickers discussed the BoE report shown in the slide, as concrete example on this trend to lower capital. Vickers wrote a public criticism in the Journal of Financial Regulation last July (see the article here).
(see “market valuations” slide)
In addition to other problems, Vickers noted that market values of equity are now 0.5 to 0.7 as large as the book values of equity used by regulators.
(see bank “price-to-book ratios are low” and “price to book ratios of UK banks”)
There is half as much equity as we think. What once were “conservative” book values — since they do not include franchise value and option values that are reflected in market values — are now optimistic values. Price to book ratios have declined from about 2 to about a half in the UK! (see “proposal to run parallel stress tests”)
He relayed some argument over why this should not even be published, let alone used in stress tests.
(see “banking reform: job done?”)
In sum, Vickers disagrees with BoE governor Mark Carney’s summary that the job of bank reform is “now substantially complete”
Ring fencing is happening, but Basel III is much too weak on capital [and includes risk weight and book values of capital, which were gamed last time and will be gamed again -JC] and BoE is retreating on capital requirements.
A spirited discussion followed. In particular, whether the Trump executive order to revisit Dodd Frank will lead to something like the Vickers view (and that of most of the participants), of more capital, ring fencing payments and lending, and regulatory simplification, or whether, like the BoE trend, it will mean lower capital in an effort to be “competitive,” and reliance [more a hope than a plan -JC] on regulators to spot trouble and resolve lots of banks in the next crisis.
There was also much discussion about Brexit, Frexit, and a potential Italian collapse. Vickers pointed out that property values were high again in the UK, leading even its ring-fenced banks in dire trouble should there be a 25% decline in values, leading to a plain vanilla domestic crisis.