Banking: From Bagehot to Basel and back again

This is the title of a new speech/paper by Bank of England Governor – Mervyn King. This blog has said this before as well- UK policymakers are the most honest and critical about its state of policies and financial system. This one is another such piece from King.

He first discusses Bagehot’s golden words on banking and central banking.

As Bagehot knew only too well, banking crises are endemic to the market economy that has evolved since the Industrial Revolution. The words “banking” and “crises” are natural bedfellows. If love and marriage go together like a horse and carriage,  then banking and crisis go together like Oxford and the Isis, intertwined for as long as anyone can remember. Unfortunately, such crises are occurring more frequently and on an ever larger scale. Why?

For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years, bank balance sheets have grown so fast that today they are over five times annual GDP. The size of the US banking industry has grown from around 20% in Bagehot’s time to around 100% of GDP today. And, until recently, the true scale of balance sheets was understated by these figures because banks were allowed  to put exposures to entities such as special purpose vehicles off balance sheet.

Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing concentration: the largest institutions have expanded the most. Table 1 shows that the asset holdings of the top ten banks in the UK amount to over  450% of GDP, with RBS, Barclays and HSBC each individually having assets in excess of UK GDP. Table 2 shows that in the US, the top ten banks amount to over 60% of GDP, six times larger than  the top ten fifty years ago. Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960.

This story is all well-known now. The rise in size of banks has led to rise in risks. The banks had leverage ratios of 50 to 1 and resorted to wholesale markets for funding. Even one of these factors was problematic and here you had so many of them together.

He goes on to blast the current banking system as:

Of all the many ways of organising banking, the worst is the one we have today

There are many suggestions to imprive the banking system. The aim must be to align private and social costs. First he looks at simpler reforms:

  • A polluter pays tax where a levy is imposed on banking system to internalise the externalities (read costs of crisis)
  • Limit on leverage (above is price based control, this one is quantity based)
  • Ring fence those activities which are most concerned with any disruption
  • Basel -III. He says it will not be enough to prevent future crisis.
    • New capital levels required are still too low. When a crisis hits only very high levels of capital can work
    • Calculation of capital required is based on risk weighted assets. Latter is in turn dependent on historical data. The crisis happens as previous data is not good enough. So you have multiple sets of problems
    • Basel norms focuses extensively on asset side issues ignoring the liquidity and liability side of the balance sheet. When UK adopted Basel II, the bank having highest capital ratio was — Northern rock. A business is made on a funding model and when later fails business does as well. So liability side analysis is as important.

      This is quite a turn around really. In finance classes we are taught not to look at liability side of the balance sheet. There is nothing in there. Focus on assets is the mantra

    • Transition to Basel III is crazily long. Banks can make adjustments till 2019!
  •  Too Important to Fail  (Nice way to put it): There are many ifs and buts here. No clarity on how to identify these TITFs and resolve them

Very interesting review of several proposals. King then discusses a few more radical reforms which could be looked at:

  • Move capital levels several magnitudes higher  (suggested by David Miles, BoE member; need to read up)
  • Limited Purpose Banking – banks turn into a MF with no maturity mismatch (by Laurence Kotlikoff of St Louis Fed). King says an idea worth studying. Imagine this from a Governor of a central bank whose economy depends so much on finance and international finance
  • Volcker rule: functional seperation of activities

He adds regulators will never be able to keep pace with financial sector changes. He is looking forward to suggestions from UK’s Independent Commission on Banking for more ideas.

He concludes with very strong words:

A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. We know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. They represent our best guess as to what the future holds, and views about the future can change radically an  unpredictably. It is a phenomenon that we must learn to live with. But changes in expectations can create havoc with the banking system because it relies so heavily on transforming short-term debt into long-term risky assets.

For a society to base its financial system on alchemy is a poor advertisement for its rationality. Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. This crisis has already left a legacy of debt to the next generation. We must not leave them the legacy of a fragile banking system too.

I have explained the principles on which a successful reform of the system should rest. It is a program that will take many years, if not decades. But, as Bagehot concluded in Lombard Street, “I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.”

Fantastic really. Hardly gets better than this. What straight forward talking.

I was also wondering about the emphasis above. King says – But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. 

This along with above quoted words — Of all the many ways of organising banking, the worst is the one we have today — are really huge huge words. So this organisation of banking is not just worst now but has been a problem since industrial revolution days.

Am also wondering if industrial revolution had indeed happened in China, would banking have been different? Would it have have been more sober and Chinese style of banking – going slow, less aggressive etc. Well, we can never know this. Can we?

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