Banks and regulators have bold ideas to address crisis


Euromoney Skew
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As financial markets head into a self-reinforcing collapse, banks and regulators are finally getting down to serious business: blaming each other

The gloves are coming off.

On Thursday evening, the Market Monitoring Group (MMG) of the Institute of International Finance – the big banks’ trade association – identified the key risks that it believes beset the financial system.

This is a body chaired by Jacques de Larosière, former managing director of the IMF and former governor of the Banque de France, and by David Dodge, former governor of the Bank of Canada. Its members include senior representatives of leading US, European and emerging market financial institutions. 

MMG suggests that rather than making things better, regulators are making them worse. You can tell these luminaries are aggravated because their key concerns demand bold type:

“The requirement imposed by the European Banking Authority for significantly higher capital ratios compared to the announced Basel III timetable has greatly increased pressure for further deleveraging by banks—the resulting sales of bank assets, often at distressed prices, is adding to sovereign funding strains.”

As night follows day, a plea for accounting leniency follows a market collapse. The MMG claims regulators’ stress tests are stirring up fear and exacerbating the downward spiral. 

“Moreover, given the current illiquidity of the CDS market and even cash markets for some euro-area sovereigns, the requirement to mark-to-market banks’ holdings of sovereign debt including in “held to maturity” portfolios and loan books is damaging. Specifically, this adds a significant element of procyclicality in the financial system.”

Euromoney just hopes the monitoring group never has to resort to underlined and upper case as well as bold, because surely then the end will be at hand.

Mervyn King was also busy on Thursday presenting the Bank of England’s financial stability report. Perhaps the Bank should now call it the instability report. The BoE's governor sees what the banks see:

“Many European governments are seeing the price of their bonds fall, undermining banks’ balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks’ balance sheets further. This spiral is characteristic of a systemic crisis.”

And what does the Bank of England expect banks to do in these circumstances? Raise capital, of course. The Bank of England is serious too. You can tell because it also uses bold:

“First, following its recommendation from September, and given the current exceptionally threatening environment, the Committee recommends that, if earnings are insufficient to build capital levels further, banks should limit distributions and give serious consideration to raising external capital in the coming months.”

The Bank of England ties itself up in knots. Banks under UK regulators’ jurisdiction aren’t under-capitalized, it stresses. That might imply that regulators have somehow failed. It’s just that the banks need bigger capital buffers. And rather than adjust capital ratios by selling assets, the Bank of England wants banks themselves to increase levels of capital. It leaves the minor details of who in their right mind might provide this capital to banks for others to wrestle with.

John-Paul Crutchley, banks analyst at UBS, reminds us that this is no way to get out of the mess:

“The fundamental problem is that the risk-free instrument on which the liquidity mechanism of the banking system is based, and that also provides its back-stop capital, has become risky. And therefore you have a non-functioning banking system.”

But the regulators did come up with one useful clarification that doesn’t seem to have been picked up on: that this might be the time for banks to run down their liquidity buffers, not build them up. Hector Sants, at the FSA, was at pains to make all of this clear:

“It's really important to understand: the FSA does not impose binding rules in the area of liquidity. We did ... in 2007, introduce a new approach to liquidity management. And in the first half of this year – 2011 – we did require firms to build up a liquidity buffer. And I think it's recognised by the banks that it has been a very helpful intervention by us, and it has certainly ensured that in the current difficult market conditions they have a buffer that they can utilise.”

We'll simply have to take Sants’ word for this because every banker Euromoney speaks to complains about being forced to build buffers of government bonds that have turned out, for the most part, to be high risk and illiquid as well as low yielding, so reducing the earnings with which they might have bolstered capital while introducing potential losses that will eat into it.

Sants suggests that banks and the media – yes, we thought we would not turn out to be entirely blameless – have got confused about the liquidity buffer:

“It's intended to be used in exactly the sort of circumstances in which we find ourselves. So the current constraint on liquidity is market conditions; it's not the FSA's framework.”

So, there we have it. None of this is the regulator’s fault.

- Euromoney Skew Blog