To make banks strong, do away with the regulator
13 May 2020
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4 July 2024
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.
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.
5 thoughts on “To make banks strong, do away with the regulator”
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This is nonsense.
Capital is an accounting concept, broadly the excess of a company’s assets over liabilities. This is a stable number. Market capitalisation is driven by a company’s share price, and hence expectations of future profits. This is a volatile number.
UK and European banks have had low price to book ratios over the last 10 years because investors (rightly) consider that ultra low interest rates crimp bank’s profits.
Banks have lots of capital and liquidity, so they are safe, but their returns are lower than their cost of capital, so their share prices (and hence market capitalisations) are low.
Whether banks have ENOUGH capital to cope with the coming wave of bad debts is another matter. I suspect they do, but it might be tight.
“This is nonsense.”
Pray clarify what the nonsense is.
“Capital is an accounting concept, broadly the excess of a company’s assets over liabilities. This is a stable number. Market capitalisation is driven by a company’s share price, and hence expectations of future profits. This is a volatile number.”
Market cap is a perfectly valid measure of capital – I would say it is the best capital measure – and Dean Buckner’s and my report (which my blog posting links to) explains why in considerable detail.
Merely asserting that X is a stable number and Y is a volatile one doesn’t get you very far.
“UK and European banks have had low price to book ratios over the last 10 years because investors (rightly) consider that ultra low interest rates crimp bank’s profits.”
Our report has an extensive discussion of the possible interpretations of low PtB ratios including a debunking of the argument you are making.
This said, I am sure that ultra low interest rates are an important factor underlying low PtB ratios.
The main issue with low PtB ratios however is simply this: low PtBs, whatever their interpretation, signal that something is wrong with the banking system. You seem to imply as much in your next paragraph, where you observe that banks’ returns are lower than their cost of capital.
“Banks have lots of capital …”
Your evidence being what, exactly? The high CET1 ratios highlighted by the BoE, perhaps? Or book values, or CET1?
Here is mine: as of May 1, the big 5 banks had a market cap = 148.5 bn. Their total assets at end 2019 were £5,445.6 bn with an implied leverage of 36.7. That is a very low amount of capital in context and an awful lot of leverage.
You might say use, e.g., book value shareholder equity instead. If we do that, then given the 42.7% average PtB, the book value becomes 148.5/0.427 = £348 bn, which is a lot more but still leaves the banks’ very highly leveraged. But to repeat, book value is not the best measure to use.
“Whether banks have ENOUGH capital to cope with the coming wave of bad debts is another matter. I suspect they do, but it might be tight.”
Banks don’t HAVE capital, they ISSUE it. To say that banks ‘have’ capital is to suggest that a bank’s capital is an asset to it. This is incorrect. A bank’s capital is a form of liability to the bank that issues it. Placing bank capital on the wrong side of the balance sheet is an elementary error, also discussed in our report. You are far from being the only one to make this error, however.
If banks market cap is £148.5 bn, then losses > that number wipe out the (market) capital of the banks. I am sure the banks’ losses will exceed £150 billion. “Tight” is not quite the word I would use.
Thanks for your comments.
“Capital is an accounting concept, broadly the excess of a company’s assets over liabilities. This is a stable number. ”
But capital is a liability (to the shareholders of a company). So the excess of assets over liabilities is zero?
“…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…”
Kevin, is this not a form of regulation?
And where was the 20% figure plucked from? Might it not be better for investors to assess for themselves whether they think that the bank is holding enough capital? An appropriate level must surely depend on the type of lending in which the bank is engaged, so why should it be a standard across the industry? Do we not want investors to exercise their own judgement rather than trusting to regulation?
>is this not a form of regulation?
It is, in truth. I would much prefer no central bank, no regulator and no state or central bank regulation, i.e., free or laissez-faire banking. But in a ‘second best’ world where deposit insurance, LOLR and so create incentives for banks to take excessive risks, then the next best thing is to constrain that excessive risk-taking via some (hopefully simple) form of capital regulation.
>And where was the 20% figure plucked from?
There is an extensive discussion of this issue in our report
http://eumaeus.org/wordp/wp-content/uploads/2020/05/Can%20UK%20banks%20pass%20the%20COVID-19%20stress%20test%206%20May%202020.pdf
>Might it not be better for investors to assess for themselves whether they think that the bank is holding enough capital?
Banks don’t hold capital, they issue it. But to answer your substantive point, the answer would be ‘yes’ in an ideal laissez-faire world and ‘no’ in a world where the state and its agencies create incentives for banks to take excessive risks.
>An appropriate level must surely depend on the type of lending in which the bank is engaged, so why should it be a standard across the industry?
What would you suggest as an alternative? Risk weights and risk models are very gameable.
Do we not want investors to exercise their own judgement rather than trusting to regulation?
Ideally, yes, but we don’t want banks taking excessive risks.