Carney’s delusions of regulatory grandeur
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.”
It makes clear that financial markets are inherently incapable of allocating risk-adjusted capital effectively thanks to a fundamental imbalance between a large supply of financial capital and deficient real-economy demand in countries with decent fundamentals, accounting for inevitable credit excesses.
It’s all the more unusual then that Carney is openly embracing the growth of the financial industry, banks and shadow counterparties, to grow the UK economy – perhaps, akin to the US policymakers’ push in the 1990s for consumer spending to power growth amid Bill Clinton’s deficit goals.
It comes even as the UK government backtracks from the BoE’s calls for a tougher leverage ratio. Carney has argued the global financial crisis has underscored the allure of imposing a high leverage ratio for banks, a non-risk based prudential tool to complement minimum capital adequacy requirements, citing the resilience of Canadian banks – supervised under a strict leverage ratio regime – in the crisis.
As a result, last December he said he disagreed with the UK government’s recent white paper, in response to the Independent Commission on Banking (ICB), led by Sir John Vickers, that decided to apply the international minimum of 3%, rather than the ICB-recommended 4.06% ratio.
What’s more, Andy Haldane, responsible for financial supervision at the BoE, argued last year that a 3% minimum was pitifully low.
“Most banks would say a loan-to-value ratio of 97% was imprudent for a borrower,” he said. “A 3% leverage ratio means banks are just such a borrower. For the world’s largest banks, the leverage ratio needed to guard against failure in this crisis would have been above 7%.”
He argued leverage ratios, rather than risk-based capital regimes, were better predictors of crises. Even former Fed chair Alan Greenspan thinks the leverage ratio should be 10% or higher. By contrast, the equity thresholds of global capital-market orientated banks, European lenders, in particular, remain a source of systemic risk, as the following charts lay bare.
|Source: Morgan Stanley|
Carney argues that new regulations – greater loss-absorbing capital, charges in banks’ trading books, more punitive risk-weighting of assets and greater supervisory vigilance – should help compensate for the generous leverage ratio, combined with greater market pressures for higher equity thresholds. However, by throwing caution to the wind, Carney has demonstrated remarkable faith in these regulations and potentially misjudges the defining monetary challenge of the post-Lehman era: macro-prudential regulation.
As a thoroughly modern central banker, Carney was a pioneer at the Bank of Canada (BoC) by arguing prudential risk-taking should be in the monetary policy kit, and led the charge to change the BoC’s mandate so it could, in theory, hike interest rates in a counter-cyclical fashion to counter asset bubbles, even when inflation deviates from target. But what is macro-prudential regulation anyway?
A May paper published by the Stern School of Business at New York University highlights that the term ‘macro-prudential’ regulation was first introduced by Andrew Crockett, former head of the Bank for International Settlements, only in a speech in 2001, defining it as “limiting the costs to the economy from financial distress” as opposed to supervisory intervention to reduce the instability of an individual institution, for consumer-protection purposes.
However, is Carney speaking the language of a macro-prudential regulator, imposing capital charges as a micro-prudential regulator, while, through the BoE’s newly expansive liquidity tools, facilitating the growth of systemic risk?
The Stern paper makes clear that macro-prudential regulators should insist upon much higher equity thresholds than micro-prudential regulators so “it can absorb a recession shock without recapitalizing. It should require the bank to build a capital buffer in good times in excess of the regulatory minimum.”
It goes further: “That is, [a bank] should be required to retain earnings and constrain expansion in an upturn so that it maintains a capital asset ratio of [for example] 12%, which would enable it to absorb a recession shock of a 4% decline in asset values without fire sales or other efforts to deleverage that can cause a contagious bank crisis.
“In short, the macro-prudential perspective implies that banks should maintain much higher levels of capital. Current standards around the world are based on micro-prudential thinking.
“Banks, particularly large interconnected institutions, should be maintaining capital ratios of 12% to 15% or more in good times. Only in Switzerland have bank regulators acknowledged this perspective and introduced sharply higher capital requirements. In the US and elsewhere, banks have so far successfully lobbied against any such proposals, claiming that it would reduce the availability of credit.”
Given London’s deepening role in intermediating the growth of global financial assets, the tax bias towards leverage, and regulatory equity thresholds for UK banks that remain a source of huge systemic risk from the BoE’s own analysis, Carney’s trillion-sterling bet on new regulatory standards seems remarkable.