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Posts Tagged ‘Basel III’

Ten years on

Ten years ago (on 9 August 2007), the French bank BNP Paribas sparked international concern when it admitted that it didn’t know what many of its investments in the US sub-prime property market were worth and froze three of its hedge funds. This kicked off the financial crisis and the beginning of the credit crunch.

In September 2007 there was a run on the Northern Rock bank in the UK, forcing the Bank of England to provide emergency funding. Northern Rock was eventually nationalised in February 2008. In July 2008, the US financial authorities had to provide emergency assistance to America’s two largest mortgage lenders, Fannie Mae and Freddie Mac.

Then in September 2008, the financial crisis really took hold. The US bank, Lehman Brothers, filed for bankruptcy, sending shock waves around the global economy. In the UK, Lloyds TSB announced that it was taking over the UK’s largest mortgage lender, Halifax Bank Of Scotland (HBOS), after a run on HBOS shares.

Later in the month, Fortis, the huge Belgian banking, finance and insurance company, was partly nationalised to prevent its bankruptcy. Also the UK government was forced to take control of mortgage-lender, Bradford & Bingley’s, mortgages and loans, with the rest of the business sold to Santander.

Early in October 2008, trading was suspended in the main Icelandic banks. Later in the month, the UK government announced a £37 billion rescue package for Royal Bank of Scotland (RBS), Lloyds TSB and HBOS. Then in November it partially nationalised RBS by taking a 58% share in the bank. Meanwhile various other rescue packages and emergency loans to the banking sector were taking place in other parts of the world. See here for a timeline of the financial crisis.

So, ten years on from the start of the crisis, have the lessons of the crisis been learnt. Could a similar crisis occur again?

The following articles look at this question and the answers are mixed.

On the positive side, banks are much more highly capitalised than they were ten years ago. Moves by the Basel Committee on Banking Supervision in its Basel III regulatory framework have ensured that banks are much more highly capitalised and operate with higher levels of liquidity. What is more, banks are generally more cautious about investing in highly complex and risky collateralised assets.

On the negative side, increased flexibility in labour markets, although helping to keep unemployment down, has allowed a huge squeeze on real wages as austerity measures have dampened the economy. What is more, household debt is rising to possibly unsustainable levels. Over the past year, unsecured debt (e.g. personal loans and credit card debt) have risen by 10% and yet (nominal) household incomes have risen by only 1.5%. While record low interest rates make such loans relatively affordable, when interest rates do eventually start to rise, this could put a huge strain on household finances. But if households start to rein in their borrowing, this would put downward pressure on aggregate demand and jeopardise economic growth.

Articles
The crisis: 10 years in three chart BBC News, Simon Jack (9/8/17)
Darling: ‘Alarm bells ringing’ for UK economy BBC News (9/8/17)
Alistair Darling warns against ‘complacency’ 10 years on from financial crisis The Telegraph (9/8/17)
A decade after the financial crisis consumers are still worried Independent, Kate Hughes (9/8/17)
Bankers still do not understand complex reasons behind financial crash, senior politician warns Independent, Ashley Cowburn (9/8/17)
We let the 2007 financial crisis go to waste The Guardian, Torsten Bell (9/8/17)
Bank of England warns of complacency over big rise in personal debt The Guardian, Larry Elliott (24/7/17)
On the 10th anniversary of the global financial meltdown, here’s what’s changed USA Today, Kim Hjelmgaard (8/8/17)
Financial crisis: Ten years ago today the tremors started Irish Times (9/8/17)
If We Are Racing to the Pre-Crisis Bubble, Here Are 12 Charts To Watch Bloomberg, Sid Verma (9/8/17)

Videos
The financial crisis ten years ago to the day Euronews (9/8/17)
Ten years later: What really sparked the financial crisis Sky News, Adam Parsons (9/8/17)
Bank of England warns on household debt Channel 4 News, Siobhan Kennedy (25/7/17)

Questions

  1. Explain what are meant by ‘collateralised debt obligations (CDOs)’.
  2. What part did CDOs play in the financial crisis of 2007–8?
  3. In what ways is the current financial situation similar to that in 2007–8?
  4. In what ways is it different?
  5. Explain the Basel III banking regulations.
  6. To what extent has the Bank of England exceeded the minimum Basel III requirements?
  7. Explain what is meant by ‘stress testing’ the banks? Does this ensure that there can never be a repeat of the financial crisis?
  8. Why is it desirable for central banks eventually to raise interest rates to a level of around 2–3%? Why might it be difficult for central banks to do that?
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Too tough or not tough enough? Developing Basel III banking rules

Under the auspices of the Bank for International Settlements (BIS), banks around the world are working their way towards implementing tougher capital requirements. These tougher rules, known as ‘Basel III’, are due to come fully into operation by 2019.

This third version of international banking rules was agreed after the financial crisis of 2008, when many banks were so undercapitalised that they could not withstand the dramatic decline in the value of many of their assets and a withdrawal of funds.

Basel III requires banks to have much more capital, especially common equity capital. The point about equity (shares) is that it’s a liability that does not have to be repaid. If people hold bank shares, the bank does not have to repay them and does not even have to pay any dividends. In other words, the money raised by issuing shares carries no obligation on the part of the bank and can thus provide a buffer against large-scale withdrawal of funds.

Under Basel III, banks have to maintain sufficiently large ‘capital-adequacy ratios’. As Essentials of Economics (7th edition) explains:

Capital adequacy is a measure of a bank’s capital relative to its assets, where the assets are weighted according to the degree of risk. The more risky the assets, the greater the amount of capital that will be required.

A measure of capital adequacy is given by the capital adequacy ratio (CAR). This is given by the following formula:

Common Equity Tier 1 (CET1) capital includes bank reserves (from retained profits) and ordinary share capital (equities), where dividends to shareholders vary with the amount of profit the bank makes… Additional Tier 1 (AT1) capital consists largely of preference shares. These pay a fixed dividend (like company bonds), but although preference shareholders have a prior claim over ordinary shareholders on the company’s (i.e. the bank’s) profits, dividends need not be paid in times of loss.

Tier 2 capital is subordinated debt with a maturity greater than 5 years. Subordinated debt holders only have a claim on a company (a bank) after the claims of all other bondholders have been met.

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. Under the Basel III accord, cash and government bonds have a risk factor of zero and are thus not included. Interbank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages under 60% of the value of the property have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

Basel III gives minimum capital requirements that are higher than under its predecessor, Basel II. Thus, by 2019, banks must have a common equity capital to risk-weighted assets of at least 4.5% and a Tier 1 ratio of at least 6.0%. The overall CAR should be at least 8%. In addition, the phased introduction of a ‘capital conservation buffer’ from 2016 will raise the overall CAR to at least 10.5 per cent.

Over the past few years, banks have increased their capital cushions significantly and many have exceeded the Basel III requirements, even for 2019.

But the Basel Committee has been reconsidering the calculation of risk-weighted assets. Because of the complexity of banks’ asset structures, which tend to vary significantly from country to country, it is difficult to ensure that banks’ are meeting the Basel III requirements. Under proposed amendments to Basel III (which some commentators have dubbed ‘Basel IV’), banks would have to compare their own calculations with a ‘standardised’ model. Their own calculations of risk-based assets would then not be allowed to be lower than 60–90% (known as ‘the output floor’) of the standardised approach.

While, on the surface, this may seem reasonable, European banks have claimed that this would penalise them, as some of their assets are less risky than the equivalent assets in other countries. For example, Germany has argued that mortgage defaults have been rare and thus German mortgage debt should be given a lower weighting than US mortgage debt, where defaults have been more common. If all assets were assessed according to the output floor, several banks, especially in Europe, would be judged to be undercapitalised. As The Economist article states:

Analysts at Morgan Stanley estimate that global, non-American banks could see risk-weighted assets rise by an average of 18–30%, depending on the level of the output floor. Extra capital of €250bn–410bn could be needed, a tall order when earnings are thin and investors wary. The committee’s reviews of operational and market risks would add even more.

This question of an output floor was a sticking point at the Basel Committee meeting in Santiago, which ended on 30 November. Although some progress was made about agreeing to rules on risk weighting that could be applied globally, a final agreement will have to wait until the next meeting, in January – at the earliest.

Articles
Basel bust-up: A showdown looms over bank-capital rules The Economist (26/11/16)
Bank regulators fail to agree on new rules Manila Standard (2/12/16)
Bank chief Claudio Borio urges regulators to ‘stay strong’ Weekend Australian, Michael Bennet (29/11/16)
Final Basel III rules meet resistance from Europe The Straits Times (2/12/16)
This Is the Absolutely Worst Time to Weaken Global Bank Rules American Banker, Mayra Rodriguez Valladares (2/12/16)
New Basel banking rules’ impact on European economy Financial Times, Frédéric Oudéa (28/12/16)
Banks like RBS still look risky, but getting too tough could cause greater problems The Conversation, Alan Shipman (1/12/16)

BIS publications
International banking supervisory community meets to discuss the regulatory framework BIS Press Release (1/12/16)
Basel III: international regulatory framework for banks Bank for International Settlements
Basel III phase-in arrangements Basel Committee on Banking Supervision, BIS
Basel Committee on Banking Supervision reforms – Basel III, Summary Table Basel Committee on Banking Supervision, BIS

Questions

  1. Why do reserves in banks have a zero weighting in terms of risk-based assets?
  2. What items have a 100% weighting? Explain why.
  3. Examine the table, Basel III phase-in arrangements, and explain each of the terms.
  4. If banks are forced to operate with a higher capital adequacy ratio, what is this likely to do to bank lending? Explain. How are funding costs relevant to your answer?
  5. Explain each of the items in the Basel III capital-adequacy requirements shown in the chart above.
  6. What is the American case for imposing an output floor?
  7. What is the European banks’ case for using their own risk weighting?
  8. Why is it proposed that larger ‘systemically important banks’ (SIBs) should have an additional capital requirement?
  9. How does the balance of assets of American banks differ from that of European banks?
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Deeper in debt

‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?

The doomsday scenario is that we are heading for another financial crisis as over leveraged banks and governments could not cope with a collapse in confidence. Bank and bond interest rates would soar and debts would be hard to finance. The world could head back into recession as credit became harder and more expensive to obtain. Perhaps, in such a scenario, there would be mass default, by banks and governments alike. This could result in a plunge back into recession.

The more optimistic scenario is that private-sector debt is under control and in many countries is falling (see, for example, chart 1 in the blog Looking once again through Minsky eyes at UK credit numbers for the case of the UK). Even though private-sector debt could rise again as the world economy grows, it would be affordable provided that interest rates remain low and banks continue to build the requisite capital buffers under the Basel III banking regulations.

As far as public-sector debt is concerned, as a percentage of GDP its growth has begun to decline in advanced countries as a whole and, although gently rising in developing and emerging economies as a whole, is relatively low compared with advanced countries (see chart). Of course, there are some countries that still face much larger debts, but in most cases they are manageable and governments have plans to curb them, or at least their growth.

But there have been several warnings from various economists and institutes, as we saw in the blog post, Has the problem of excess global debt been tackled? Not according to latest figures. The question is whether countries can grow their way out of the problem, with a rapidly rising denominator in the debt/GDP ratios.

Only mass default will end the world’s addiction to debt The Telegraph, Jeremy Warner (3/3/15)

Questions

  1. What would be the impact of several countries defaulting on debt?
  2. What factors determine the likelihood of sovereign defaults?
  3. What factors determine the likelihood of bank defaults?
  4. What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
  5. What are the Basel III regulations? What impact will they have/are they having on bank leverage?
  6. Expand on the arguments supporting the doomsday scenario above.
  7. Expand on the arguments supporting the optimistic scenario above.
  8. What is the relationship between economic growth and debt?
  9. Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
  10. Is domestic inflation a good answer for a country to the problems of rising debt denominated (a) in the domestic currency; (b) in foreign currencies?
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Global deflation danger

Christine Lagarde, managing director of the IMF, has warned of the danger of deflation in the eurozone. She also spoke of the risks of a slowdown in the developing world as the Fed tapers off its quantitative easing programme – a programme that has provided a boost to many emerging economies.

Speaking at the World Economic Forum, in the Swiss Alps, she did acknowledge signs of recovery across the world, but generally her speech focused on the risks to economic growth.

Some of these risks are old, such as a lack of fundamental bank reform and a re-emergence of risky behaviour by banks. Banks have taken steps towards recapitalisation, and the Basel III rules are beginning to provide greater capital buffers. But many economists believe that the reforms do not go far enough and that banks are once again beginning to behave too recklessly.

Some of the risks are new, or old ones resurfacing in a new form. In particular, the eurozone, with inflation of just 0.8%, is dangerously close to falling into a deflationary spiral, with people holding back on spending as they wait for prices to fall.

Another new risk concerns the global impact of the Fed tapering off its quantitative easing programme (see Tapering off? Not yet). This programme has provided a considerable boost, not just to the US economy, but to many emerging economies. Much of the new money flowed into these economies as investors sought better returns. Currencies such as the Indian rupee, the Brazilian real and the Turkish lira are now coming under pressure. The Argentinean peso has already been hit by speculation and fell by 11% on 24/1/14, its biggest one-day fall since 2002. Although a fall in emerging countries’ currencies will help boost demand for their exports, it will drive up prices in these countries and put pressure on central banks to raise interest rates.

Christine Lagarde was one of several speakers at a session titled, Global Economic Outlook 2014. You can see the complete session by following the link below.

Articles
Lagarde warns of risks to global economic recovery TVNZ (27/1/14)
Lagarde Cautions Davos on Global Deflation Risk Bloomberg News, Ian Katz (26/1/14)
Davos 2014: Eurozone inflation ‘way below target’ BBC News (25/1/14)
IMF fears global markets threat as US cuts back on cash stimulus The Guardian, Larry Elliott and Jill Treanor (25/1/14)
Davos 2014: looking back on a forum that was meant to look ahead The Guardian, Larry Elliott (26/1/14)

Speeches at the WEF
Global Economic Outlook 2014 World Economic Forum (25/1/14)

Questions

  1. Why is deflation undesirable?
  2. What are the solutions to deflation? Why is it difficult to combat deflation?
  3. What are the arguments for the USA tapering off its quantitative easing programme (a) more quickly; (b) less quickly?
  4. How is tapering off in the USA likely to affect the exchange rates of the US dollar against other currencies? Why will the percentage effect be different from one currency to another?
  5. What are Japan’s three policy arrows (search previous posts on this site)? Should the eurozone follow these three policies?
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Five years on from Lehman’s: what have we learned?

On 15 September 2008, Lehman Brothers, the fourth-largest investment bank in the USA, filed for bankruptcy. Although the credit crisis had been building since mid 2007, the demise of Lehmans was a pivotal event in the unfolding of the financial crisis and the subsequent severe recession in most developed economies. Banks were no longer seen as safe and huge amounts of government money had to be poured into banks to shore up their capital and prevent further bankruptcies. Partial nationalisation seemed the only way of rescuing several banks and with it the global financial system.

A deep and prolonged recession followed (see Chart 1: click here for a PowerPoint). In response, governments pursued expansionary fiscal policies – at least until worries about rising government deficits and debt caused a lurch to austerity policies. And central banks pursued policies of near zero interest rates and subsequently of quantitative easing. But all the time debate was taking place about how to reform banking to prevent similar crises occurring in the future.

Solutions have included reform of the Basel banking regulations to ensure greater capital adequacy. The Basel III regulations (see Chart 2) demand considerably higher capital ratios than the previous Basel II regulations.

Other solutions have included proposals to break up banks. Indeed, just this week, the Lloyds Banking Group has hived off 631 of its branches (one sixth of the total) into a newly reformed TSB. Another proposal is to ring-fence the retail side of banks from their riskier investment divisions. In both cases the aim has been to avoid the scenario where banks are seen as too big to fail and can thus rely on governments to bail them out if they run into difficulties. Such reliance can make banks much more willing to take excessive risks. Further details of the new systems now in place are given in the Robert Peston article below.

But many critics maintain that not nearly enough has been done. Claims include:

• The Basel III rules are not tough enough and banks are still being required to hold too little capital.
• Rewards to senior bankers and traders are still excessive.
• The culture of banking, as a result, is still too risk loving in banks’ trading arms, even though they are now much more cautious about lending to firms and individuals.
• This caution has meant a continuing of the credit crunch for many small businesses.
• Higher capital adequacy ratios have reduced bank lending and have thus had a dampening effect on the real economy.
• The so-called ring-fences may not be sufficient to insulate retail banking from problems in banks’ investment divisions.
• Banks are not being required to hold sufficient liquidity to allow them to meet customers’ demands for cash in all scenarios.
• Banks’ reliance on each other still leaves a systemic risk for the banking system as a whole.
• Fading memories of the crisis are causing urgency to tackle its underlying problems to diminish.
• Problems may be brewing in less regulated parts of the banking world, such as the growing banking sector in China.

The following articles look at the lessons of the banking crisis – those that have been learned and those that have not. They look at the measures put in place and assess whether they are sufficient.

Lehman Brothers collapse, five years on: ‘We had almost no control’ The Guardian, Larry Elliott and Jill Treanor (13/9/13)
Lehman Brothers collapse: five years on, we’re still feeling the shockwaves The Guardian, Larry Elliott (13/9/13)
Five years after Lehman, could a collapse happen all over again? The Observer, Larry Elliott and Jill Treanor (15/9/13)
Five years after Lehman, all tickety-boo? BBC News, Robert Peston (9/9/13)
What have we learned from the bank crash? Independent, Yalman Onaran, Michael J Moore and Max Abelson (14/9/13)
We’ve let a good financial crisis go to waste since Lehman Brothers collapsed The Telegraph, Jeremy Warner (12/9/13)
The Lehman legacy: Lessons learned? The Economist (9/9/13)
The dangers of debt: Lending weight The Economist (14/9/13)
The Lehman anniversary: Five years in charts The Economist (14/9/13)

Questions

  1. Why did Lehman Brothers collapse?
  2. Explain the role of the US sub-prime mortgage market in the global financial crisis of 2007/8.
  3. In the context of banking, what is meant by (a) capital adequacy; (b) risk-based capital adequacy ratios; (c) leverage; (d) leverage ratios?
  4. Explain the Basel III rules on (a) risk-based capital adequacy (see the textbook and the chart above); (b) non-risk-based leverage (introduced in 2013: see here for details).
  5. Explain and comment on the following statement by Adair Turner: ‘We created an over-leveraged financial system and an over-leveraged real economy. We created a system such that even if the direct cost of bank rescue was zero, the impact of their near-failure on the economy was vast.’
  6. Under what circumstances might the global financial system face a similar crisis to that of 2007/8 at some point in the future?
  7. Why is there an underlying conflict between increasing banks’ required capital adequacy and ensuring a sufficient supply of credit to consumers and business? What multiplier effects are likely to occur from an increase in the capital adequacy ratio?
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Financialisation: Banks and the economy after the crisis

In the blogs The capital adequacy of UK banks and A co-operative or a plc? we focus on how British banks continue to look to repair their balance sheets. To do so, banks need to ‘re-balance’ their balance sheets. This may involve them holding more reserves and equity capital and/or a less risky and more liquid profile of assets. The objective is to make banks more resilient to shocks and less susceptible to financial distress.

This will take time and even then the behaviour of banks ought to look like quite different from that before the financial crisis. All of this means that we will need to learn to live with new banking norms which could have fundamental consequences for economic behaviour and activity.

The increasing importance of financial institutions to economic activity is known as financialisation. It is not perhaps the nicest word, but, in one way or another, we all experience it. I am writing this blog in a coffee shop in Leicester having paid for my coffee and croissant by a debit card. I take it for granted that I can use electronic money in this way. Later I am going shopping and I will perhaps use my credit card. I take this short term credit for granted too. On walking down from Leicester railway station to the coffee shop I walked past several estate agents advertising properties for sale. The potential buyers are likely to need a mortgage. In town, there are several construction sites as Leicester’s regeneration continues. These projects need financing and such projects often depend on loans secured from financial institutions.

We should not perhaps expect economic relationships to look as they did before the financial crisis. The chart shows how levels of net lending by financial institutions to households have dramatically fallen since the financial crisis. (Click here for PowerPoint of chart.)

Net lending measures the amount of lending by financial institutions after deducting repayments. These dramatically smaller flows of credit do matter for the economy and they do affect important macroeconomic relationships.

Consider the consumption function. The consumption function is a model of the determinants of consumer spending. It is conventional wisdom that if we measure the growth of consumer spending over any reasonably long period of time it will basically reflect the growth in disposable income. This is less true in the short run and this is largely because of the financial system. We use the financial system to borrow and to save. It allow us to smooth our consumption profile making spending rather less variable. We can save during periods when income growth is strong and borrow when income growth is weak or income levels are actually falling. All of this means that in the short term consumption is less sensitive to changes in disposable income that it would otherwise be.

The financial crisis means new norms for the banking system and, hence, for the economy. One manifestation of this is that credit is much harder to come by. In terms of our consumption function this might mean consumption being more sensitive to income changes that it would otherwise be. In other words, consumption is potentially more volatile as a result of the financial crisis. But, the point is more general. All spending activity, whether by households or firms, is likely to be more sensitive to economic and financial conditions than before. For example, firms’ capital spending will be more sensitive to their current financial health and crucially to their flows of profits.

We can expect particular markets and sectors to be especially affected by new financial norms. An obvious example is the housing market which is very closely tied to the mortgage market. But, any market or sector that traditionally is dependent on financial institutions for finance will be affected. This may include, for example, small and medium-sized enterprises or perhaps organsiations that invest heavily in R&D. It is my view that economists are still struggling to understand what the financial crisis means for the economy, for particular sectors of the economy and for the determination of key economic relationships, such as consumer spending and capital spending. What is for sure, is that these are incredibly exciting times to study economics and to be an economist.

Data
Statistical Interactive Database Bank of England

Articles
Cut in net lending to non-financial firms raises credit worries Herald Scotland, Mark Williamson (25/5/13)
Loans to business continue to shrink despite Funding for Lending Scheme Wales Online, Chris Kelsey (3/6/13)
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Co-operative Bank to list on stock market in rescue deal The Guardian, Jill Treanor (17/6/13)
Troubled Co-operative Bank unveils rescue plan to plug £1.5bn hole in balance sheet Independent, Nick Goodway (17/6/13)
Co-op Bank announces plan to plug £1.5bn hole Which?(17/6/13)
The Co-operative Bank and the challenge of finding co-op capital The Guardian, Andrew Bibby (13/6/13)
Co-op Bank seeks to fill £1.5bn capital hole Sky News (17/6/13)
Central banks told to head for exit Financial Times, Claire Jones (23/6/13)
Stimulating growth threatens stability, central banks warn The Guardian (23/6/13)

BIS Press Release and Report
Making the most of borrowed time: repair and reform the only way to growth, says BIS in 83rd Annual Report BIS Press Release (23/6/13)
83rd BIS Annual Report 2012/2013 Bank for International Settlements (23/6/13)

Questions

  1. What is meant by equity capital?
  2. How can banks increase the liquidity of their assets?
  3. Explain how Basel III is intended to increase the financial resilence of banks.
  4. What do you understand by the term ‘financialisation’? Use examples to illustrate this concept.
  5. How might we expect the financial crisis to affect the detemination of spending by economic agents?
  6. Using an appropriate diagram, explain how a reduction in capital spending could affect economic activity? Would this be just a short-term effect?
  7. What does it mean if we describe households as consumption-smoothers? How can households smooth their spending?
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The capital adequacy of UK banks

The Prudential Regulation Authority is the new UK authority in charge of banking regulation and is part of the Bank of England. In a report published on 20/6/13, the PRA found that UK banks had a capital shortfall of £27.1 billion (see Chart 1 below for details) if they were to meet the 7% common equity tier 1 (CET1) ratio: one of the capital adequacy ratios (CARs) specified under the Basel III rules (see Rebuilding UK banks: not easy to do and Chart 2 below).

CET1 includes bank reserves and ordinary share capital (‘equities’). To derive the CET1 ratio, CET1 is expressed as a percentage of risk-weighted assets. As Economics for Business (6th ed) page 467 states:

Risk-weighted assets are the total value of assets, where each type of asset is multiplied by a risk factor. …Cash and government bonds have a risk factor of zero and are thus not included. Inter-bank lending between the major banks has a risk factor of 0.2 and is thus included at only 20 per cent of its value; residential mortgages have a risk factor of 0.35; personal loans, credit-card debt and overdrafts have a risk factor of 1; loans to companies carry a risk factor of 0.2, 0.5, 1 or 1.5, depending on the credit rating of the company. Thus the greater the average risk factor of a bank’s assets, the greater will be the value of its risk weighted assets, and the lower will be its CAR.

The data published by the PRA, based on end-2012 figures, show that the RBS group is responsible for around 50% of the capital shortfall, the Lloyds Banking Group around 32%, Barclays around 11%, the Co-operative around 5.5% and Nationwide the remaining 1.5%. HSBC, Santander and Standard Chartered met the 7% requirement. The PRA found that banks already were taking measures to raise £13.7bn, but this still leaves them requiring an additional £13.4 for current levels of lending.

So what can the banks do? They must either raise additional capital (the numerator in the CAR) or reduce their risk-weighted assets (the denominator). Banks hope to be able to raise additional capital. For example, Lloyds is planning to sell government securities and US mortgage-backed securities and hopes to have a CET1 ratio of around 10% by the end of 2013. Generally, the banks aim to raise the required level of capital through income generation, the sale of assets and restructuring, rather than from issuing new shares.

What both the Bank of England and the government hope is that banks do not respond by reducing lending. While that might enable them to meet the 7% ratio, it would have an undesirable dampening effect on the economy – just at a time when it is hoped that the economy is starting to recover. As Robert Peston states:

I understand that both Barclays and Nationwide feel a bit miffed about being forced to hit this tough so-called leverage ratio at this juncture, because they are rare in that they have been supporting economic recovery by increasing their net lending.

They now feel they are being penalised for doing what the government wants. So I would expect there to be something of a spat between government and regulators about all this.

Articles
Factbox – Capital shortfalls for five UK banks, mutuals Standard Chartered News (20/6/13)
UK banks ordered to plug £27.1bn capital shortfall The Guardian, Jill Treanor (20/6/13)
Barclays, Co-op, Nationwide, RBS and Lloyds responsible for higher-than-expected capital shortfall of £27.1bn The Telegraph, Harry Wilson (20/6/13)
UK banks need to plug £27bn capital hole, says PRA BBC News (20/6/13)
Barclays and Nationwide forced to strengthen BBC News, Robert Peston (20/6/13)
Five Banks Must Raise $21 Billion in Fresh Capital: BOE Bloomberg, Ben Moshinsky (20/6/13)
Will Nationwide be forced to become a bank? BBC News, Robert Peston (4/7/13)

PRA news release and data
Prudential Regulation Authority (PRA) completes capital shortfall exercise with major UK banks and building societies Bank of England: Prudential Regulation Authority (20/6/13)

Questions

  1. Explain what are meant by the various Basel III capital adequacy requirements
  2. What are the banks which were identified as having a capital shortfall doing about it?
  3. Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
  4. Would the raising of additional capital allow additional credit creation to take place? Explain.
  5. What other constraints are there on bank lending?
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Keynes versus the Classics: a new version of an old story

The ‘Classical’ Treasury view of the 1920s and 30s was that extra government spending or tax cuts were not the solution to depression and mass unemployment. Instead, it would crowd out private expenditure if the money supply were not allowed to rise as it would drive up interest rates. But if money supply were allowed to rise, this would be inflationary. The solution was to reduce budget deficits to increase confidence in public finances and to encourage private investment. Greater price and wage flexibility were the answer to markets not clearing.

Keynes countered these arguments by arguing that the economy could settle in a state of mass unemployment, with low confidence leading to lower consumer expenditure, lower investment, lower incomes and lower employment. The situation would be made worse, not better, by cuts in public expenditure or tax rises in an attempt to reduce the budget deficit. The solution was higher public expenditure to stimulate aggregate demand. This could be achieved by fiscal and monetary policies. Monetary policy alone could, however, be made ineffective by the liquidity trap. Extra money might simply be held rather than spent.

This old debate has been reborn since the financial crisis of 2007/8 and the subsequent deep recession and, more recently, the lack of recovery. (Click here for a PowerPoint of the chart.)

The articles below consider the current situation. Many economists, but certainly not all, take a Keynesian line that austerity policies to reduce public-sector deficits have been counter-productive. By dampening demand, such policies have reduced national income and slowed the recovery in both investment and consumer demand. This has at best slowed the rate of deficit reduction or at worst even increased the deficit, with lower GDP leading to a reduction in tax receipts and higher unemployment leading to higher government social security expenditure.

Although monetary policy has been very loose, measures such as record low interest rates and quantitative easing have been largely ineffective in stimulating demand. Economies are stuck in a liquidity trap, with banks preferring to build their reserves rather than to increase lending. This is the result partly of a lack of confidence and partly of pressure on them to meet Basel II and III requirements of reducing their leverage.

But despite the call from many economists to use fiscal policy and more radical monetary policy to stimulate demand, most governments have been pre-occupied with reducing their deficits and ultimately their debt. Their fear is that rising deficits undermine growth – a fear that was given weight by, amongst others, the work of Reinhart and Rogoff (see the blog posts Reinhart and Rogoff: debt and growth and It could be you and see also Light at the end of the tunnel – or an oncoming train?.

But there is some movement by governments. The new Japanese government under Shinzo Abe is following an aggressive monetary policy to drive down the exchange rate and boost aggregate demand (see A J-curve for Japan?) and, more recently, the European Commission has agreed to slow the pace of austerity by giving the Netherlands, France, Spain, Poland, Portugal and Slovenia more time to bring their budget deficits below the 3% of GDP target.

Of course, whether or not expansionary fiscal and/or monetary policies should be used to tackle a lack of growth does not alter the argument that supply-side policies are also required in order to increase potential economic growth.

A Keynesian Victory, but Austerity Stands Firm The New York Times, Business Day, Eduardo Porter (21/5/13)
With Austerity Under Fire, Countries Seek a More Balanced Solution Knowledge@Wharton (22/5/13)
Keynes, Say’s Law and the Theory of the Business Cycle History of Economics Review 25.1-2, Steven Kates (1996)
Is Lord Keynes back in Brussels? The Conversation, Fabrizio Carmignani (31/5/13)
Keynes’s Biggest Mistake The New York Times, Business Day, Bruce Bartlett (7/5/13)
Keynes’s Not So Big Mistake The New York Times, The Conscience of a Liberal blog, Paul Krugman (7/5/13)
The Chutzpah Caucus The New York Times, The Conscience of a Liberal blog, Paul Krugman (5/5/13)
Keynes and Keynesianism The New York Times, Business Day, Bruce Bartlett (14/5/13)
Japan Is About To Prove Keynesian Economics Entirely Wrong Forbes, Tim Worstall (11/5/13)
The poverty of austerity exposed Aljazeera, Paul Rosenberg (24/5/13)
Britain is a lab rat for George Osborne’s austerity programme experiment The Guardian, Larry Elliott (26/5/13)
Eurozone retreats from austerity – but only as far as ‘austerity lite’ The Guardian, Larry Elliott (30/5/13)
Europe’s long night of uncertainty Daily Times (Pakistan), S P Seth (29/5/13)
Abenomics vs. bad economics The Japan Times Gregory Clark (29/5/13)
European countries to be allowed to ease austerity BBC News (29/5/13)
U.K. Should Restore Growth, Rebalance Economy IMF Survey (22/5/13)
Now everyone is a Keynesian again – except George Osborne The Observer, William Keegan (2/6/13)
Austerity Versus Growth (III): Fiscal Policy And Debt Sustainability Social Europe Journal, Stefan Collignon (30/5/13)

Questions

  1. Explain what is meant by Say’s Law and its implication for macroeconomic policy.
  2. Why have many governments, including the UK government, been reluctant to pursue expansionary fiscal policies?
  3. What is meant by the liquidity trap? What is the way out of this trap?
  4. In the first article above, Eduardo Porter argues that ‘moral views are getting in the way of reason’. What does he mean by this?
  5. Explain what are meant by the ‘paradox of thrift’ and the ‘fallacy of composition’. How are these two concepts relevant to the debate over austerity policies?
  6. What are the dangers in pursuing aggressive Keynesian policies?
  7. What are the dangers in not pursuing aggressive Keynesian policies?
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Rebuilding UK banks: not easy to do

Following the banking crisis of 2007/8 a new set of international banking regulations was agreed in 2010 by the Basel Committee on Banking Supervision. The purpose was to strengthen banks’ capital base. Under ‘Basel III’, banks would be required, in stages, to meet specific minimum capital adequacy ratios: i.e. minimum ratios of capital to (risk-weighted) assets. The full regulations would come into force by 2019. These are shown in the chart below.

The new Financial Policy Committee of the Bank of England has judged that some UK banks have insufficient ‘common equity tier 1 capital’. This is defined as ordinary shares in the bank plus the bank’s reserves. According to the Bank of England:

… the immediate objective should be to achieve a common equity tier 1 capital ratio, based on Basel III definitions and, after the required adjustments, of at least 7% of risk-weighted assets by end 2013. Some banks, even after the adjustments described above, have capital ratios in excess of 7%; for those that do not, the aggregate capital shortfall at end 2012 was around £25 billion.

Thus the banking system in the UK is being required, by the end of 2013, to meet the 7% ratio. This could be done, either by increasing the amount of capital or by reducing the amount of assets. The Bank of England is keen for banks not to reduce assets, which would imply a reduction in lending. Similarly, it does not want banks to increase reserves at the expense of lending. Either action could push the economy back into recession. Rather the Bank of England wants banks to raise more capital. But that requires sufficient confidence by investors.

And the end of this year is not the end of the process. After that, further increases in capital will be required, so that by 2019 banks are fully compliant with Basel III. All this will make it difficult for certain banks to raise enough capital from investors. As far as RBS and the Lloyds Banking Group are concerned, this will make the prospect of privatising them more difficult. But that is what the government eventually wants. It does not want the taxpayer to have to find the extra capital. Re-capitalising the banks, or at least some of them, may prove difficult.

The following articles look at the implications of the FPC judgement and whether strengthening the banks will strengthen or weaken the rest of the economy.

Articles
Financial policy committee identifies £25bn capital shortfall in UK banks The Guardian, Jill Treanor (27/3/13)
Banks Told To Raise Capital By Financial Policy Committee To Cushion Against A Crisis Huffington Post (27/3/13)
UK banks’ £25bn shortfall: positive for banks, negative for BoE credibility, Sid Verma (27/3/13)
Doubts over Bank of England’s £25bn confidence game The Telegraph, Harry Wilson (27/3/13)
Bank of England tells banks to raise £25bn BBC News (27/3/13)
Q&A: Basel rules on bank capital – who cares? Laurence Knight (13/9/10)
U.K. Banks Seen Avoiding Share Sales After BOE Capital Review Bloomberg Businessweek, Gavin Finch and Howard Mustoe (27/3/13)
Banks Cut Basel III Shortfall by $215 Billion in Mid-2012 Bloomberg (19/3/13)
Will strengthening banks weaken the economy? BBC News, Robert Peston (27/3/13)

Bank of England News Release
Financial Policy Committee statement from its policy meeting, 19 March 2013 Bank of England (27/3/13)

Questions

  1. Explain the individual parts of the chart.
  2. What do you understand by risk-weighted assets?
  3. Distinguish between capital adequacy ratios and liquidity ratios.
  4. What could the banks do to increase their capital adequacy ratios? Compare the desirability of each method.
  5. If all banks around the world were Basel III compliant, would this make another global banking crisis impossible?
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A cap fit for purpose?

As part of the Basel III round of banking regulations, representatives of the EU Parliament and member governments have agreed with the European Commission that bankers’ bonuses should be capped. The proposal is to cap them at 100% of annual salary, or 200% with the agreement of shareholders. The full Parliament will vote in May and then it will go to officials from the 27 Member States. Under a system of qualified majority voting, it is expected to be accepted, despite UK resistance.

The main arguments in favour of a cap are that it will reduce the focus of bankers on short-term gains and reduce the incentive to take excessive risks. It will also appease the anger of electorates throughout the EU over bankers getting huge bonuses, especially in the light of the recession, caused in major part by the excesses of bankers.

The main argument against is that it will drive talented top bankers to countries outside the EU. This is a particular worry of the UK government, fearful of the effect on the City of London. There is also the criticism that it will simply drive banks into increasing basic salaries of senior executives to compensate for lower bonuses.

But it is not just the EU considering curbing bankers’ pay. The Swiss have just voted in a referendum to give shareholders the right to veto salaries and bonuses of executives of major companies. Many of these companies are banks or other financial sector organisations.

So just what will be the effect on incentives, banks’ performance and the movement of top bankers to countries without such caps? The following videos and articles explore these issues. As you will see, the topic is highly controversial and politically charged.

Meanwhile, HSBC has revealed its 2012 results. It paid out $1.9bn in fines for money laundering and set aside a further $2.3bn for mis-selling financial products in the UK. But its underlying profits were up 18%. Bonuses were up too. The 16 top executives received an average of $4.9m each. The Chief Executive, Stuart Gulliver, received $14.1m in 2012, 33% up on 2011 (see final article below).

Webcasts and podcasts
EU moves to cap bankers bonuses Euronews on Yahoo News (1/3/13)
EU to Curb Bank Bonuses WSJ Live (28/2/13)
Inside Story – Curbing Europe’s bank bonuses AlJazeera on YouTube (1/3/13)
Will EU bonus cap ‘damage economy’? BBC Radio 4 Today Programme (28/2/13)
Swiss back curbs on executive pay in referendum BBC News (3/3/13)
Has the HSBC scandal impacted on business? BBC News, Jeremy Howell (4/3/13)

Articles
Bonuses: the essential guide The Guardian, Simon Bowers, Jill Treanor, Fiona Walsh, Julia Finch, Patrick Collinson and Ian Traynor (28/2/13)
Q&A: EU banker bonus cap plan BBC News (28/2/13)
Outcry, and a Little Cunning, From Euro Bankers The New York Times, Landon Thomas Jr. (28/2/13)
Bank bonuses may shrink – but watch as the salaries rise The Observer, Rob Taylor (3/3/13)
Don’t cap bank bonuses, scrap them The Guardian, Deborah Hargreaves (28/2/13)
Capping banker bonuses simply avoids facing real bank problems The Telegraph, Mats Persson (2/3/13)
Pro bonus The Economist, Schumpeter column (28/2/13)
‘The most deluded measure to come from Europe since fixing the price of groceries in the Roman Empire’: Boris Johnson attacks EU banker bonus cap Independent, Gavin Cordon , Geoff Meade (28/2/13)
EU agrees to cap bankers’ bonuses BBC News (28/2/13)
Viewpoints: EU banker bonus cap BBC News (28/2/13)
Voters crack down on corporate pay packages swissinfo.ch , Urs Geiser (3/3/13)
Swiss voters seen backing executive pay curbs Reuters, Emma Thomasson (3/3/13)
Swiss referendum backs executive pay curbs BBC News (3/3/13)
Voters in Swiss referendum back curbs on executives’ pay and bonuses The Guardian, Kim Willsher and Phillip Inman (3/3/13)
Swiss vote for corporate pay curbs Financial Times, James Shotter and Alex Barker (3/3/13)
HSBC pays $4.2bn for fines and mis-selling in 2012 BBC News (4/3/13)

Questions

  1. How does competition, or a lack of it, in the banking industry affect senior bankers’ remuneration?
  2. What incentives are created by the bonus structure as it is now? Do these incentives result in desirable outcomes?
  3. How would you redesign the bonus system so that the incentives resulted in beneficial outcomes?
  4. If bonuses are capped as proposed by the EU, how would you assess the balance of advantages and disadvantages? What additional information would you need to know to make such an assessment?
  5. How has the relationship between banks and central banks over the past few years created a moral hazard? How could such a moral hazard be eliminated?
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