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
- Explain what are meant by the various Basel III capital adequacy requirements
- What are the banks which were identified as having a capital shortfall doing about it?
- Would it be desirable for banks to issue additional shares? Would this make the banks more secure?
- Would the raising of additional capital allow additional credit creation to take place? Explain.
- What other constraints are there on bank lending?
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
- Explain what is meant by Say’s Law and its implication for macroeconomic policy.
- Why have many governments, including the UK government, been reluctant to pursue expansionary fiscal policies?
- What is meant by the liquidity trap? What is the way out of this trap?
- In the first article above, Eduardo Porter argues that ‘moral views are getting in the way of reason’. What does he mean by this?
- 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?
- What are the dangers in pursuing aggressive Keynesian policies?
- What are the dangers in not pursuing aggressive Keynesian policies?
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
- Explain the individual parts of the chart.
- What do you understand by risk-weighted assets?
- Distinguish between capital adequacy ratios and liquidity ratios.
- What could the banks do to increase their capital adequacy ratios? Compare the desirability of each method.
- If all banks around the world were Basel III compliant, would this make another global banking crisis impossible?
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
- How does competition, or a lack of it, in the banking industry affect senior bankers’ remuneration?
- What incentives are created by the bonus structure as it is now? Do these incentives result in desirable outcomes?
- How would you redesign the bonus system so that the incentives resulted in beneficial outcomes?
- 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?
- 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?
In the wake of the financial crisis of 2007/8, the international banking regulatory body, the Basel Committee on Banking Supervision, sought to ensure that the global banking system would be much safer in future. This would require that banks had (a) sufficient capital; (b) sufficient liquidity to meet the demands of customers.
The Basel III rules set new requirements for capital adequacy ratios, to be phased in by 2019. But what about liquidity ratios? The initial proposals of the Basel Committee were that banks should have sufficient liquid assets to be able to withstand for at least 30 days an intense liquidity crisis (such as that which led to the run on Northern Rock in 2007). Liquid assets were defined as cash, reserves in the central bank and government bonds. This new ‘liquidity coverage ratio’ would begin in 2015.
These proposals, however, have met with considerable resistance from bankers, who claim that higher liquidity requirements will reduce their ability to lend and reduce the money multiplier. This would make it more difficult for countries to pull out of recession.
In response, the Basel Committee has published a revised set of liquidity requirements. The new liquidity coverage ratio, instead of being introduced in full in 2015, will be phased in over four years from 2015 to 2019. Also the definition of liquid assets has been significantly expanded to include highly rated equities, company bonds and mortgage-backed securities.
This loosening of the liquidity requirements has been well received by banks. But, as some of the commentators point out in the articles, it is some of these assets that proved to be wholly illiquid in 2007/8!
Articles
Banks Win 4-Year Delay as Basel Liquidity Rule Loosened BloombergJim Brunsden, Giles Broom & Ben Moshinsky (7/1/13)
Banks win victory over new Basel liquidity rules Independent, Ben Chu (7/1/13)
Banks win concessions and time on liquidity rules The Guardian, Dan Milmo (7/1/13)
Basel liquidity agreement boosts bank shares BBC News (7/1/13)
Banks agree minimum liquidity rules BBC News, Robert Peston (67/1/13)
The agreement
Group of Governors and Heads of Supervision endorses revised liquidity standard for banks BIS Press Release (6/1/13)
Summary description of the LCR BIS (6/1/13)
Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools BIS (6/1/13)
Introductory remarks from GHOS Chairman Mervyn King and the Basel Committee on Banking Supervision’s Chairman Stefan Ingves (Transcript) BIS (6/1/13)
Questions
- What is meant by ‘liquid assets’?
- How does the liquidity of assets depend on the state of the economy?
- What is the relationship between the liquidity ratio and the money multiplier?
- Does the size of the money multiplier depend solely on the liquidity ratio that banks are required to hold?
- Distinguish between capital adequacy and liquidity.
- What has been the effect of quantitative easing on banks’ liquidity ratios?
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).
