FSA plays dangerous game with relaxation of capital rules

In Blog by Ian Fraser0 Comments

October 10th, 2012

Today the Financial Services Authority formally relaxed capital and liquidity rules on UK banks in the vague hope this might kickstart lending and do something to ensure the UK economy can pick itself up off the floor.

The Canary Wharf-based regulator also said that it would not require banks to hold extra capital against new lending that qualifies for a “funding for lending” (FLS) scheme targeted at loans to corporate borrowers. The FSA insists the policy changes were well flagged up in advance following the Bank of England’s Financial Policy Committee in September.

The moves follow a warning last Friday, October 5th, from analysts at Morgan Stanley that British banks could need up to £22bn of additional capital if regulators follow through with threats to change the risk-weightings they apply to mortgages in assessing the size of their loan books. “Regulators need to strike a balance between raising banks’ capital levels and not stifling economic recovery,” the Morgan Stanley report said.

However, in broad terms, the moves seem a massive u-turn for the regulator, chaired since 2008 by Lord Turner. Until now, all the talk from the Bank of England in Threadneedle Street and the FSA in Docklands has been that banks must further bolster their capital ratios — especially in view of the risk of a disintegration of the eurozone.  Minutes of the MPC’s September meeting also suggested that the FPC wants UK banks to tap external investors for further capital.

The FSA is, in my view, playing a dangerous game with these decisions, and it is a game that’s replete with moral hazard.

Today, FPC member Robert Jenkins reaffirmed his view that banks are, if anything, likely to need more capital, not less, and urged bank shareholders to support the bolstering of bank balance sheets. Jenkins said:-

“The old financial structure has crumbled and a new edifice is rising. But its foundation is flawed, the walls are thin and the beams are brittle. The good news: there is still time for you to weigh in and strengthen the structure. Begin with the foundation. The foundation is capital.”

Dr Enrique Schroth (pictured above right), reader in finance at Cass Business School, was no less underwhelmed by the UK regulator’s decision to relax capital rules, warning that it is likely to store up problems for the future, since it would almost inevitably bring on laxer lending standards. Schroth said:

“The incentives of banks to screen loan quality could decrease significantly if banks expect the FSA to relax capital requirements during recessions but leave them intact during booms. Lending may increase, but at the expense of higher default probabilities, and more severe recessions in the future.

“The real problem is not so much the use of risk-based capital targets per se, as opposed to the way default probabilities and credit ratings are measured. Basel III prescribes conservation buffers that address that issue, but they will only come in full force in 2019. Until then, banks will naturally start making forecasts of the FSA’s reactions, and the FSA will have to develop a reputation of sticking to rules set in stone or acting discretionally. Is the FSA ready to play that game?”

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