23rd August 2012
However, there is a widespread view among bankers that the biggest risks facing the sector going forward are the unintended consequences that are likely to flow from regulatory initiatives like Basel III and political initiatives to curb pay and bonus excesses. No surprises there, of course: after the party comes the clean up, and who enjoys that?
In a recent speech before the Worshipful Company of Actuaries, Robert Jenkins, a member of the Bank of England's Financial Policy Committee, took a close look at the substance of complaints from bankers, starting from the incontrovertible premise that, as he put it, "regulation is a growth industry." Banker complaints, he noted, fall into three categories: regulation is (a) too tough, (b) too damaging, and (c) too prolific.
"The first assertion is that the regulations are too tough; that the boys in Basel are bonkers…" he says. (The tone and style of his speech, it has to be said, is refreshing and somewhat surprising coming from an FPC member-no reason why they can't be witty instead of dry, but few have been as robust and as straightforward as Jenkins). The Basel regulations, Jenkins points out, in their Mark I and Mark II forms, certainly could not be accused of being "tough." Zero weighting for sovereign debt, even Greek/Irish/Portuguese/Italian/Spanish debt. "Restricting" leverage to 33×, when hedge funds, the most risk-loving part of the professional investment world, typically leverage to 3×. Assuming that a bank's mortgage book was sufficiently capitalised against risk by holding 0.86p of capital for every £100 lent on a 100% mortgage. And CDO squared securities? Here only 0.46p per £100 was required, and we all know how that turned out. This is not tough regulation by anyone's standards.
So how much tougher is Basel III? Well, the new rules would require 1.35p for every £100 of CDO squared investment. As Jenkins notes, this is "a loss absorbing capability of less than 1.4% for a risk that most rating agencies, regulators, bankers and investors misjudged." And sovereign bonds are still zero risk (though that may change). Jenkins notes that Basel III is determined to cap bank leverage. However, he points out, that cap is scheduled to be set at 33× leverage! Plus the new rules don't take effect till 2019; lots of time to play high, wide, and handsome before these mild constraints kick in.
The second complaint, "too damaging," has as its focus the concern that higher capital requirements will force banks to cut back on lending, leading to a dampening down of GDP growth in the overall global economy. Jenkins does a fast pass through this, basically showing that if a bank increases its equity by 50%, under duress from the regulatory authorities, say going to $100 billion of capital on a $1 trillion loan book, and as a result retires $50 billion of debt, it has improved, rather than shrunk its balance sheet, putting it in a better position to lend. Bankers then complain that this shrinks their return on equity (RoE) since it halves the leverage and leverage boosts RoE as any private equity house will tell you. But what this complaint does not take into account is that the market, right now, is "attaching relatively higher valuations to the relatively less leveraged." In other words, investors have got the point that massive leverage equates to massive risk and are favouring less risky banks, boosting their share price in the process. So a bank could make relatively lower RoE, i.e. lower earnings, and still be more attractive to investors than a bank with a higher RoE but that was maxed out on leverage.
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