The Daily Reckoning UK

What Does Carney Really Mean By “Safer”?

Ben Traynor

by

Posted 7th April 2017

“There should be no bonfire of financial regulation,” said Bank of England Governor Mark Carney towards the end of a speech he made this morning.

The man is worried. The political winds have changed, and he knows it.

Carney clearly feels there’s a growing appetite for deregulation.

And he fears it will undermine efforts to “promote financial stability”, to use his phrase.

Take the calls in the US to bring back a version of Glass-Steagall, the Depression-era legislation that separated commercial and investment banks, and which was repealed in 1999.

On the surface, you can make the case for this being a cross-party effort to address the too-big-to-fail problem.

Commercial banking activities won’t be compromised by the speculative activities of the investment bankers.

Investment banks that get in trouble can be allowed to go to the wall, in the knowledge that commercial banking can chug on as normal.

That’s the idea.

More regulation, not less. Financial stability duly promoted. No need for taxpayer bailouts.

However, as this article by Bloomberg View’s Joe Nocera argues, “Bring back Glass-Steagall” means different things to different people.

“When Trump Administration officials like [National Economic Council Director Gary] Cohn (and Treasury Secretary Steven Mnuchin) talk about bringing back Glass-Steagall, they have something else in mind,” Nocera writes.

“Yes, they also want to prevent future bailouts. But what they really want is to use Glass-Steagall as a way of providing cover for other actions that could be characterized as ‘unduly favorable to Wall Street,’ as the banking analyst Karen Petrou wrote recently.”

Closer to home, Carney says that “how the Brexit negotiations conclude will be a litmus test for responsible financial globalisation.”

Carney is fighting to preserve and build on a legacy of regulation he repeatedly claims has made the system safer.

But is that really true?

At the heart of the post-2008 regulatory push has been the effort to make banks build up higher capital buffers.

The logic is this: Carney and his fellow financial system overseers want banks to absorb the losses when the assets on their balance sheets fall in value.

So, for example, if someone defaults on a mortgage, the bank takes a loss. It holds the mortgage as an asset, and now that it ain’t gonna be paid back, it’s worth a lot less than they previously thought.

The problem last time round was that banks couldn’t cover all the losses they faced. The system had to be bailed out.

The official solution: make banks hold more capital so that they can cover the losses.

The line is that the bigger capital buffers banks now have has made the system “safer”.

But what do people like Carney actually mean by “safer”?

The notion really conflates two distinct ideas.

One is a reduced risk of a crisis happening in the first place.

The other is that another crisis will happen sooner or later but will do less damage when it hits.

A Vox column published today, titled What has bank capital ever done for us? suggests that the latter idea is much closer to reality.

The researchers behind it looked at banking data going back to 1870.

One of the questions they sought to answer was whether the size of capital buffer – as measured by banks’ capital ratios – was a good predictor of when a crisis was nigh.

If so, it would be good evidence that increasing capital ratios makes financial crisis less likely.

I respect your privacy and will never pass on your email address to anyone else.

However…

“We find that the capital ratio provides virtually no information about the probability of a systemic financial crisis,” the researchers write.

By contrast, they found credit growth was a useful predictor of financial crisis.

Bottom line, then, if banks are lending at a faster and faster rate, expect trouble ahead.

But if they say “Nah, don’t worry, we’ve got nice and big capital ratios”, ignore them!

Actually, it gets a tad worse…

“Higher capital ratios are associated, if anything, with a higher probability of a crisis,” the researchers say.

“This mechanism is consistent with banks raising capital in response to higher-risk lending choices, rather than as a buffer against a potential systemic crisis event in the economy. In fact, as we know from recent experience, banking systems may appear to be well capitalised on the eve of crises.”

Well that’s a bit scary.

It raises the prospect that central bankers like Carney are cheerily welcoming higher capital ratios that could actually be a sign of banks taking on MORE risk.

Which is a sobering thought…

There’s a bit more optimism when we consider the second idea, that higher capital ratios may dampen the pain when a crisis hits.

“A more highly levered financial sector at the start of a financial-crisis recession is associated with slower subsequent output growth and a significantly weaker cyclical recovery,” the researchers find.

“More highly levered”, of course, is the flip side of having a lower capital ratio.

Ergo, the research implies, a higher capital ratio means lower leverage and a quicker recovery after a crisis.

The researchers’ conclusion is pretty clear here:

“We find that macroprudential policy, here in the form of higher capital ratios, can lower the costs of a financial crisis even if it cannot prevent it.”

For you as investor the takeaway is clear.

You cannot rely on the official safeguards touted by regulators like Carney.

The best we can realistically hope for is that they limit the damage after the next crisis hits.

As for preventing it in the first place – let’s not be so complacent.

You still need to be ready for a financial panic – and in particular for the official response that will follow. Click here to see how you should prepare.

 

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