21 September 2017

Financial Times: Banking remains far too undercapitalised for comfort

Banks create money as a byproduct of their lending activities. The latter are inherently risky. That is the purpose of lending. But banks’ liabilities are mostly money. The most important purpose of money is to serve as a safe source of purchasing power in an uncertain world. Unimpeachable liquidity is money’s point. Yet bank money is least reliable when finance becomes most fragile. Banks cannot deliver what the public wants from money when the public most wants them to do so.

This system is designed to fail. To deal with this difficulty, a source of so much instability over the centuries, governments have provided ever-increasing quantities of insurance and offsetting regulation. The insurance encourages banks to take ever-larger risks. Regulators find it very hard to keep up, since bankers outweigh them in motivation, resources and influence.

A number of serious people have proposed radical reforms. Economists from the Chicago School recommended the elimination of fractional reserve banking in the 1930s. Mervyn King, former governor of the Bank of England, has argued that central banks should become “pawnbrokers for all seasons”: thus, banks’ liquid liabilities could not exceed the specified collateral value of their assets. One thought-provoking book, The End of Banking by Jonathan McMillan, recommends the comprehensive disintermediation of finance.

All these proposals try to separate the risk-taking from the public’s holdings of unimpeachably safe liquid assets. Combining these two functions in one class of institutions is a recipe for disaster, because the first function compromises the second, and so demands huge and complex interventions by the state. That is simply not a market solution.

Senior officials argue that capital requirements have increased 10-fold. Yet this is true only if one relies on the alchemy of risk-weighting. In the UK, actual leverage has merely halved, to around 25 to one. In brief, it has gone from the insane to the merely ridiculous.

The smaller the equity funding of a bank, the less it can afford to lose before it becomes insolvent. A bank near insolvency must not be allowed to operate, since shareholders have nothing left to lose from taking huge bets. There is, however, a simple way of increasing the confidence of a bank’s creditors in the value of its liabilities (without relying on government support). It is to reduce its leverage from 25 to one to, say, five to one, as argued by Anat Admati and Martin Hellwig in The Bankers’ New Clothes.

As Sir John notes, this would impose private costs on bankers, which is why they hate the idea. But it would not impose significant costs on society at large. Yes, there would be a modest increase in the cost of bank credit, but bank credit has arguably been too cheap. Yes, the growth of bank-created money might slow, but there exist excellent alternative ways of creating money, especially via the balance sheets of central banks. Yes, shareholders would not like it. But banking is far too dangerous to be left to them alone. And yes, one can invent debt liabilities intended to convert into equity in crises. But these are likely to prove difficult to operate in a crisis and are, in any case, an unnecessary substitute for equity.

Full article on Financial Times (subscription required)

© Financial Times