Carney’s delusions of regulatory grandeur

Sid Verma
Published on:

Given the tax bias towards leverage, and regulatory equity thresholds for UK banks that remain a source of systemic risk from the Bank of England's own analysis, the governor is gambling that new, untested regulatory standards will temper systemic risk - even while gunning for the expansion of the financial industry.

Source: Columbia Pictures
Mark Carney boasts the looks and stature of a US president in an apocalyptic Hollywood movie. It’s hard to imagine Mervyn King playing the American hero who comforts a nation, in the face of adversity, powered purely by his confidence and charisma.

However, rather than imitating Bill Pullman in Independence Day, what if the current Bank of England (BoE) governor is stuck in the regulatory bunker after a nuclear financial button is accidentally set off, à la Dr Strangelove?

After all, the chances of another financial disaster in the UK have hardly vanished, with low global rates, systemic leverage of the banking system and potential policy missteps.

On the latter, last month, Carney shocked bank reformers after he suggested the central bank would accept an extraordinarily wide range of collateral at its monthly auction in exchange for continued funding.

Finn Poschmann is vice-president, research, at the CD Howe Institute
In an opinion piece for Euromoney, Finn Poschmann, vice-president, research, at the CD Howe Institute in Toronto, said: “Continuous liquidity access for the shadow banking system is a superb route to that system’s expansion, and for collateral to go forth and multiply.”

More specifically, Carney mooted the possibility of finance – four times the size of national income – growing, as a proportion of GDP, to nine times by 2050, buoyed by the growth of emerging financial markets and London’s comparative advantage as a global hub.

For his detractors, Carney, chairman of the Financial Stability Board at Basel – a rule-setting body set up to reform global finance post-Lehman – has invested extraordinary faith in the power of regulators to stem systemic risk. That confidence seems misguided.

As the former head of a global regulatory body told Euromoney at an IMF meeting: “The only way to redress systemic risk is through a higher leverage ratio and the removal of the debt bias in developed-world tax systems.

“Instead, supervisors have gone down the path of unleashing an extraordinarily complex regulatory system, which they know will inevitably fail at some point because that’s the nature of markets.”

Both a removal of the tax bias in favour of equity and substantially higher common equity thresholds for banks are off the agenda.

On the first, the deductibility of corporate interest payments misaligns incentives by favouring leverage over equity and its removal would by the single simplest way of reducing unsustainably high debt burdens, in all sectors, says the ex-regulator.

Bill Pullman, star of Independence Day.
Source: 20th Century Fox
Staff papers produced by the IMF have long called for the removal of the debt bias in tax systems, but note the political hurdles. Guillermo Ortiz, the respected former head of the Central Bank of Mexico, and a member of the G30, told Euromoney last year, after a G30 report: “This is highly political but there should be a debate about removing the tax bias in favour of debt.”

Former ECB governor Jean-Paul Trichet and ex-Fed chair Paul Volcker have also thrown their weight behind the proposal in recent years.

However, no debate among policymakers has been forthcoming, as fiscal authorities have an incentive to boost home ownership amid rising income inequality, and fear regulatory arbitrage, clashes with treaty obligations, the volatile financial impact and the political fallout amid the abrupt transfer of wealth that would ensue, among other factors, say former policymakers off the record.

This accounting trick adds fuel to the leverage fire. Carney’s sanguine attitude towards the growth of finance and the ability of superhero regulators to detect and mitigate systemic risk is a high-gamble bet, given the tide of capital that continues to sweep the world.

According to an August report by Bain & Co, the volume of total financial assets will rise by some 50%, from $600 trillion in 2010 to $900 trillion by 2020 and real GDP itself will grow by $27 trillion. In other words, the large volume of global financial assets will continue to sit on a small base of global GDP.

Mark Carney, governor of the Bank of England
Put simply, total capital will remain 10-times larger than the total global output of goods and services in 2020, as was the case in 2010, thanks to a rise in global savings, financial innovation and leverage. This suggests Carney will be more than successful in gunning for the expansion of London as a hub for global capital.

The Bain study states: “For the balance of the decade, markets will generally continue to grapple with an environment of capital superabundance.”

In sum, economies with open capital accounts and decent fundamentals, such as the UK, will grapple with the systemic tension between the financial and the real economy.

The report concludes: “We expect that inflation will not show up in core prices in most markets but rather in asset bubbles, which have moved from being relatively isolated events to system-shaking crises claiming trillions of dollars in losses.”