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The banks that fared better in the crisis were those that were more prudently capitalised. Investors as well as regulators want to ensure that this wisdom is written into the rules of the game.
The financial reforms that have been agreed will increase the quality and amount of bank capital in the system; they will also promote increases of capital buffers in good times that can be drawn down in bad times. Big, interconnected and hard-to-replace banks will carry extra capital. The authorities are working to ensure that no bank is too complex to be wound down. They are refining new liquidity standards. And they are taking unprecedented steps to make sure that the new regulations are implemented effectively across countries. The outcome should be a stronger financial system. But regulation is only part of the answer and stronger market discipline will also be necessary to ensure resilience.
Mr Caruana presented the case that, over the long term, there is no conflict between shareholder value and the public interest in safer banking. This proposition is supported by the record of return on equity and bank share price performance – a record that refutes the argument that banks have used leverage to produce sustained shareholder value – and the key word here is “sustained”. Bank returns may have been comparatively high in good times. But those returns have melted away in bad times. And they have come at the cost of greater risk. In the long run, bank business models have produced middling returns with substantial downside risk. This means that in good times banks have overpromised and overestimated their underlying profitability. They have written put options on their liquidity and credit, and reported the premia as current income. In effect, they have made distributions out of what should have been treated as expected losses.
How can investors help banks move in the right direction? They could encourage sustainable business models based less on risk-taking and more on a careful analysis of competitive advantage and operational efficiencies. And they should be wary of entertaining unrealistic expectations about sustainable rates of return. Only when solid business models and realistic commitments to sustainable returns are rewarded can shareholder value be reconciled with safe banking. Indeed, there is no other way.