Banking Crisis: International Dimensions - Treasury Contents


Memorandum from Jan Toporowski

ECONOMICS DEPARTMENT, THE SCHOOL OF ORIENTAL AND AFRICAN STUDIES, UNIVERSITY OF LONDON AND THE RESEARCH CENTRE FOR THE HISTORY AND METHODOLOGY OF ECONOMICS, UNIVERSITY OF AMSTERDAM

EXECUTIVE SUMMARY

  It is utopian to consider the issue of international banking regulation in isolation from global macroeconomic imbalances and their financing. It highlights the role of asset inflation in giving temporary stability to financial systems, at the cost of severe damage to banking systems when that inflation ceased [paragraphs 1-3]. Prudent banking policy needs to be supplemented by accommodating fiscal policy, if only because (domestic) government debt is a stabilising factor in bank balance sheets [4-6]. But government re-capitalisation of banks may be a wasteful use of government resources [5]. The evidence takes issue with the view that the markets or independent regulators can regulate financial markets effectively or well [7-8]. The evidence criticises more extensively the view that additional equity capital cushions banks against risks in their lending. In fact such additional capital reduces the equity capital available to non-financial firms. Such firms then have to rely on debt financing. Such "forced" debt financing discourages productive investment, weakens the liquidity of the non-financial business sector, and in this way degrades the quality of bank assets [11-18]. Over-capitalisation of banks is exacerbated by cross-border lending, which under present arrangements requires more capital to be put aside [21]. The evidence concludes by suggesting an alternative system in which cross-border lending to the private sector abroad is supported by additional, contingent lending commitments to foreign governments that may be required to refinance the foreign debts of their private sector [22-24].

EVIDENCE

I.  Introduction: Banking Depends on Macroeconomic Conditions

  1.  Institutions, how they function together in markets, and how macroeconomic imbalances are accommodated are more important than principles of banking regulation abstracted from the actual intermediation functions of banks. The present crisis is not due to deregulation (which had occurred in 1980s) but precisely because commercial credit was allowed to take up the slack in the economy that arose after the dot.com bubble burst in 2000. Commercial credit was able to support consumption through housing market inflation, and corporate liquidity through capital market inflation, at the cost of rising indebtedness that emerged as excess debt when housing and financial asset prices fell.

  2.  A second disadvantage of discussing bank regulation abstracted from actual conditions of financial intermediation is the unreality of any discussion that starts with general principles of regulation when banking and financial markets are gripped, or at least driven, by crises in the U.S. and U.K. that are notable for their durability rather than their tractability. Much of the recent discussion among academic economists of "optimum" regulation in a private sector banking system, hardly addresses the current prospects for banking. The current difficulties are largely regarded as policy problems, rather than regulatory ones. Especially in the most financially advanced countries, banking will be in the state sector for a long time to come and will be affected for decades, if not years by the measures taken to deal with the crisis. Discussions of bank regulation that abstract from the banking structures being currently worked upon are either frankly utopian or else implicitly nostalgic for a recent, but receding, past when macroeconomic imbalances were accommodated by asset inflation, rather than the efficiency of deregulated banking.

  3.  The durability of the present crisis suggests that the discussion should be centred upon not so much financial regulation, but financial reconstruction. Such financial reconstruction has to take place within a broader programme of the reconstruction of our economic institutions, whose aim must be to reduce the dependence of global economic activity on financial market conjunctures. Such dependence has been embedded in the financialised economies, such as the U.S., the U.K., and Iceland, through funded pension schemes, the use of privatisation as a source of government revenue, and the increasing use of the housing market to support household consumption, while the non-financialised economies, such as Germany or China, through their increasing direct or indirect reliance on exporting to financialised economies, thereby acquired an indirect dependence on financial inflation. Economic activity must be reorganised to make the real economy more stable and financial markets more boring, so that enterprise is focussed on innovations that enhance welfare, rather than financial inflation.

  4.  The macroeconomic preconditions for financial stability must include appropriate fiscal accommodation. It is important to remember that the stability of banking and financial markets after the Second World War was not only due to regulation, but also due to the overhang of government debt largely held by banks and kept liquid by central banks. Such government debt operations must be part of any effective stabilisation of banking markets. To some extent this is already happening as government debt expands rapidly to refinance banks; stabilising banks by distributing among financial balance sheets government paper backed, in effect, by claims on banks.

  5.  An important limitation of this emergence of the government as financial intermediary to bankers is that government credit operations are being used to support credit ("finance is financing finance") rather than activity in the real economy, as happened in previous government debt expansions. There is a benefit in that it facilitates "quantitative easing", that is the purchase from banks of government paper by central banks to provide commercial banks with additional reserves. But the benefits of quantitative easing have always been greatly exaggerated: It did not have any significant economic effect in Japan when it was tried at the end of the 1990s, when the ratio of Japanese Government debt to Gross Domestic Product was approximately 150% (the U.S. and U.K. government debt to GDP ratios currently stand at 60% and 50% respectively).

  6.  A particular difficulty, which may have added to the fragility of banking systems in the U.S. and the U.K. and which today limits central bank operations with commercial banks, is the concentration of government paper in the reserves of central banks and long-term investment institutions (insurance companies and pension funds). The clear preference among long term investment institutions, partly for regulatory reasons, for government paper means that the return of ailing government-supported banks to the private sector will be limited by weak demand in the capital market for shares or common stocks. This means that banks are likely to stay in the public sector for a while. (This is further discussed in the next section of this evidence.) The discussion on bank regulation will remain utopian as long as it ignores the distinctive functions that public sector banks must perform.

  7.  On the agenda of discussions about financial reconstruction has to be elimination of so-called "independent" central banks and regulators. One of things wrong with our institutions is the narrowing of the policy agenda to consumer price inflation and employment. This allowed regulators to tolerate inflation in the financial markets and get away with it, while delegating awkward questions of regulation to an abstracted market in which "rational" agents prevail, or independent regulators who had no overview of how banks were functioning in the economy as a whole. The crisis has brought home to everyone what was apparent in the 1930s, namely that in a capitalist market economy in general, and in financial markets in particular, the "rational" generation of cash flow does not result in any kind of social equilibrium or optimum.

  8.  More importantly, in the moment of crisis, it is most obvious that the previous cash flows generated by inflation in asset markets concealed structural imbalances in those markets. Delegating regulation to market participants, or even to those experienced in generating cash flows from asset markets, ie, so-called "expert practitioners" means delegating to those acting under the influence of illusions created by those cash flows. Among those illusions is the belief, now widely held among banking experts that the banking system's exposure to macroeconomic hazard arises merely out of inter-bank financial transactions which leave banks with sizable exposures to default by a single bank (see, for example, the so-called "Geneva Report", Brunnermeier, M., Crockett, A., Goodhart, C.A.E., Persaud, A.D., and Shin, H. (2009) The Fundamental Principles of Financial Regulation, Preliminary Conference draft Geneva: International Center for Monetary and Banking Studies). Such a definition of "macro-prudential regulation", and the concern for securing the survival of "systemically important" financial institutions (ie, institutions whose default would have an adverse impact on the balance sheets of a large number of banks) reflects the "capture" of financial regulators by the institutions which they are supposed to regulate. Financial inflation expands cross-holdings of each others assets by banks in liquid markets whose cash flow creates an illusion of successful credit operations. Independent regulators will always incline to deregulation at such times. The answer is to have publicly accountable regulators imbued with an ethos of public service capable of auditing market structures and market processes, rather than practitioners whose expertise in individual balance sheet restructuring blinds them to market structures and imbalances. It is vital that a public, democratically-accountable authority be able to modify banking and financial market regulation in line with changing macroeconomic conditions, and the emergence of structural imbalances in the economy or in the financial markets. The need to coordinate such regulation with the availability of government paper to stabilise bank balance sheets suggests that this regulation should be done by an agency associated with H.M. Treasury.

II.  Capital Adequacy Requirements

  9.  Conventional wisdom since the 1980s has it that banks can be made more secure by having capital that is sufficient to meet a decline in the quality of banks' assets (loans or bonds). This thinking was reflected in the Basle Agreement of 1988, laying down minimum capital requirements in relation to the supposed riskiness of assets. Apart from the fact that there is considerable uncertainty about the precise riskiness of assets, the strategy of securing bank stability by capital adequacy is based on a fallacy of composition: what is good for one bank is not necessarily good for all banks taken together.

  10.  Essentially, the strategy is based on a microeconomic presumption that each bank can determine its liabilities (ie, the scale and distribution of its liabilities between deposits and capital) without affecting the liabilities of other banks and firms in the economy. This is a fallacy because the process of issuing capital or liabilities is subject to two constraints. The first of these is the balance sheet constraint that each bank's or firm's liabilities must be some other firm's or bank's assets. Secondly, even if one assumes that the price system (ie, the return offered and accepted on liabilities and assets) will allow all banks and firms to issue the kind of liabilities that they wish to have in their individual balance sheets, there is no guarantee that their assets will generate sufficient income to allow each individual bank or firm to make those payments on their liabilities.

  11.  In practice banks cannot determine their capital without affecting the availability of capital for other economic enterprises. If we exclude the possibility of bank holding companies and bank capital cross-holdings (see below, paragraph 20) the supply of capital today in the financially advanced markets of the OECD countries is principally determined by the cash flow and the respective liability structures of other financial intermediaries, such as pension funds and insurance companies. Given a certain capacity on the part of other, non-bank, financial intermediaries for purchasing equity, a regulatory requirement to increase bank capital reduces the amount of capital available for non-financial firms. If non-financial firms are unable to raise the amount of equity capital that they need, they are obliged to raise capital through the issue of debt instruments in the form of corporate bonds or company paper. In this way, stabilising banks by raising capital requirements becomes a way of "forcing" companies into debt.

  12.  The "enforced indebtedness" of companies is a crucial factor in bringing about financial crisis and recession. Both the 1929 Crash, and the Crash of 2007-08 were preceded by rising capital issues by financial intermediaries and the growing indebtedness of non-financial firms. The response of non-financial firms to rising levels of debt is to reduce their (productive) investment in fixed capital. Such falls in fixed capital formation are a key factor in bringing about recession in the real (non-financial) economy and, in the case of the 1930s (or in Japan after 1992) prolonging that recession into economic stagnation and depression.

  13.  The "crowding out" of the non-financial business sector's demand for capital also raises the cost to them of the eventual capital that they raise. Because banks have to satisfy a regulatory requirement for capital they are willing to pay whatever price it takes to get the capital onto their books. This "inelastic" demand for capital means that banks may end up promising a higher return on the capital that they raise. Non-financial firms wishing to raise equity capital must then match or offer even higher returns on the capital that they wish to issue. This is reflected in the rising yields on corporate equity issues since 2000.

  14.  The other way in which banks can accommodate demands for higher capital ratios (ie, ratios of capital to assets) is by securitisation, ie, by packaging up bank loans as bonds, and selling the resulting bonds to other financial intermediaries (insurance companies and pension funds). This raises banks' capital/asset ratios by reducing the amount of risky assets on those banks' balance sheets. Securitisation has recently had a bad press because of its role in the "business model" of failed banks, such as Northern Rock. But there is also another channel by which securitisation has contributed to financial fragility. This is through the sale of loan-backed bonds to other financial intermediaries. Such sales effectively reduce the pool of capital that non-financial firms can raise in the markets. This is another means of "enforced indebtedness" of companies.

  15.  "Enforced indebtedness" increases the financial fragility of the economy as a whole. Firms which would have preferred to finance themselves with equity capital find themselves holding levels of debt which over their planning horizon they would prefer to reduce. They can accommodate this excess debt in one of two ways. Firms can hold larger amounts of liquid assets (bank deposits, foreign currency deposits, short term bills). But this means that capital which they have issued is `wasted' by being held as financial assets, rather than being applied productively to the expansion of output or fixed capital. Alternatively, firms can reduce their fixed capital investment in order to build up those liquid assets. Either way, productive investment ends up being less than it would otherwise be. If sufficient firms succumb to indebtedness in this way, the economy moves to a lower growth trajectory. Fixed capital formation is a key factor in the liquidity of firms, with higher investment in fixed capital being associated with higher retained profits of firms. Lower investment in fixed capital therefore reduces the liquidity of firms and their ability to service their debts. Indirectly, therefore, the company indebtedness enforced by raising capital requirements for banks itself may cause a decline in the quality of bank assets.

  16.  Looking at this issue over the course of the business cycle, it is easy to see how regulatory bank capital requirements may make fluctuations in economic activity even more extreme. Given even moderate business fluctuations, it is prudent for non-financial firms to raise additional equity capital as a boom proceeds because the longer the boom lasts, the closer is the eventual recession, and therefore the more likely is a fall in the return on the productive assets of non-financial firms. If, however, banks are increasing their issue of equity capital, then non-financial firms may find themselves unable to issue additional equity or relying on debt finance. In this way, when the recession comes, it is made worse by the greater indebtedness of companies. In the recession the returns on all assets, including those in bank portfolios, deteriorate. To ensure their survival non-financial firms should now be converting debt into equity. But since the deterioration of their assets is obliging banks to raise more equity capital themselves, this bank capitalisation reduces the already diminishing pool of equity capital available to non-financial firms.

  17.  More recently there have been proposals to stabilise bank balance sheets by requiring banks to raise the capital to risk-weighted assets ratios over the course of an economic boom. The reason for this is that the present fixed capital to risk-weighted asset ratios is pro-cyclical in the sense that, in the course of an economic boom, the liquidity and net worth of balance sheets increases. A fixed capital ratio would therefore fail to discourage banks' risky lending and may even encourage it because the risks would be less apparent in the boom. The policy of requiring banks to raise capital ratios as a boom proceeds is sometimes referred to as "dynamic provisioning".

  18.  There are three objections to this dynamic provisioning approach. In the first place the risks that are supposed to evoke higher capital ratios are rather nebulous, and evidenced only by defaults in a recession if it comes, so that it becomes difficult to enforce higher capital ratios if the boom is prolonged. Secondly, the approach would require banks to drain the available pool of equity capital even more rapidly than under fixed capital ratios, causing a corresponding greater indebtedness on the part of companies, and forcing up even more the cost of capital that non-financial firms could issue. Far from stabilising banks and the economy, dynamic provisioning would destabilise the economy and the credit system, including banks, by indebting companies more rapidly in a boom, or else discouraging company investment, and by these means increasing the risk of companies' default on their debt. The third problem arises in an international setting in which some banks may have a diversified portfolio of assets spread across countries, some of which are in a boom, and some of which are in recession. Such banks would on balance have a much more stable portfolio of loans and could reasonable argue that they should not be required to increase their capital ratios as much as banks exposed only to countries in recession.

  19.  A far more effective form of dynamic provisioning would be to require companies (and households with mortgages, if we are to extend our considerations to household debt) to increase the equity capital that they have as a boom proceeds. This would make companies' remaining debt more manageable in the face of a recession, and thereby reduce the probability of default on that debt. The latter in turn would improve the quality of bank assets.

  20.  So far in this evidence consideration has only been given to the issue of bank capitalisation through the sale of equity capital to financial institutions such as insurance companies and pension funds. The sale of equity capital to private individuals is not an effective means of raising capital because few private individuals are wealthy enough to be able to hold significant quantities of capital on the scale required by banks. However, there is another means of raising bank capital, namely that of bank holding companies, or cross-holdings of bank capital. A bank could issue equity capital which might be held by a holding company financed mostly with debt instruments, such as bonds. Alternatively two banks could agree to issue capital to each other. The holding company method is a way of creating capital that is really debt, and this would show up in consolidated accounts. Moreover, it is a highly speculative form of financing because the holding company ends up with financial commitments that must be serviced out of less liquid assets whose value and income is much less certain that the holding company's liabilities. This is why, in the past, bank holding companies were strictly regulated. The second method gives rise to a "layering" of capital within the financial system, with banks holding other banks' capital in their assets. Such cross-holdings have adverse effects on competition among banks, on bank efficiency, and on the vulnerability of banks grouped in this way to any risks which might affect the assets of a single one of them.

III.  International bank stabilisation

  21.  The arguments presented here apply to a national economy. They apply even more to the international economy insofar as national financial systems are integrated into an international system. In a situation in which banks have cross-border exposures in the form of assets in other countries, exposures made more risky by the current mix of floating exchange rates with such rates fixed in particular regions (for example, the Euro-zone and associated member states of the European Union) the present Basle Agreement and European Commission Directives would require even higher capital ratios, than if individual bank assets and liabilities were confined to only one country. Those even higher capital ratios imply an even greater indebtedness of companies.

  22.  In such an internationally integrated financial system, banks and economies would be much more effectively stabilised if cross-border lending to the private sector were matched by a commitment to lend, in the domestic currency of the bank, to the government of the country of that private sector, in the event of lending to that country being reduced. Thus, if a bank located, for example, in the U.K. lends to companies in South Africa, the bank would commit itself to lend to the South African government the equivalent of any reduction in lending by the bank to those companies. In this way, capital outflows would be matched by new capital inflows to governments which would then be in a position to stabilise the foreign borrowing of banks and companies in their respective countries.

  23.  The government bonds thus issued to foreign banks would be long-term, or at least sufficiently long-term to avoid repayment pressures on the issuing governments in the midst of crisis. Banks holding such foreign government bonds should be given an option to sell them after a given period, but before they are repaid, to a multilateral monetary agency such as the International Monetary Fund at a price mutually agreed.

  24.  Such a system of advance, or contingent lending commitments would encourage due caution with cross-border lending, while stabilising cross-border bank capital flows. It would obviously be least taken up in countries with relatively little private sector foreign borrowing, such as some of the major OECD countries. However, smaller countries and emerging, developing and transition economies, their banks and their companies, could benefit from the greater stability that such a system would bring. In this way, contingent commitments to lend to governments in the event of private sector lending withdrawals would strengthen and stabilise the international financial system.

April 2009







 
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