December 7th, 2013 (minor edits December 8th, 2013)
Robert Jenkins, a former member of the Bank of England’s monetary policy committee, says that bankers have successfully convinced policymakers and pundits at both an G20 and a UK level that three outrageous myths are true in order to see off post-crisis regulatory reforms. According to Jenkins, a former chairman of F&C Asset Management who is now adjunct professor of finance at London Business School, the bankers’ three big lies are as follows:-
(1) “Society has to choose between safety and growth”
(2) “We have to choose between safe banks and shareholder value”
(3) “We have to choose between a safe banking system and a competitive financial marketplace championed by the national host”
He said bankers and their lobbyists have propagated these myths so effectively they have managed to defeat reform. In other words, the banks have used sabre-rattling (about choking off credit and bringing the economy to a standstill, for example. they’re forced to adhere to higher capital ratios) in order to terrify politicians and regulators into allowing them to revert to “business as usual” and to thwart re-regulation of the sector. He said the fact every key decision-maker has swallowed these myths “hook, line and sinker” means we’re headed towards a 3 per cent or 4 per cent leverage ratio, when we should be looking to one of between 16 per cent and 20 per cent. Jenkins was speaking at the Finance Watch conference in Brussels on 7 November.
I wrote about the bankers’ use of over-the-top scaremongering to kill off, neutralise or water down necessary reforms for Qfinance in June 2010, and the Sunday Herald in September 2010. I also commented on Jenkins’ “A Debate Frame by Myths” speech on this blog in September 2012.
Later during the Finance Watch conference panel session (at 59 minutes in the clip below), Robert Jenkins said the best way of restoring European citizens’ faith in banks, and the wider European project, would be to put some bankers in jail. “Somebody’s got to go to jail. You don’t even need new laws to do that, the regulators have to have the courage to use the powers that are available them today”. He referred to the FSA’s failure to use its “approved person’s regime” to strike off directors of failed banks such as HBOS and RBS.
The full session, which also featured Robert Kuttner, the American Prospect (moderator); Sharon Bowles, MEP, chair of the European Parliament’s ECON Committee; Robert Jenkins, Professor Walter Mattli, executive director, department of politics and international relations, Oxford University; Simon Lewis, chief executive of , the Association for Financial Markets in Europe, can be seen in full here:-
This summary of the event came via the Finance Watch website
Robert Kuttner said that despite many changes to supervision and resolution, the financial system itself has not changed fundamentally. Although higher capital standards made a difference, there is still a long way to go. Why is the story of reform after this recent crash so much different than it was after the 1930 crash?
Simon Lewis said that reform matters for the legitimacy of the financial sector. Basel III completely changed the scene. There has been significant progress on the key reforms on global level. There is a regular assessment of the implementation process from the Financial Stability Board (FSB). The latest one, released in September 2013, contains a letter from Governor Carney which says that the key reforms are well advanced on global level. Much of the work on the rules is complete, but at national and regional level, there is still some way to go. This makes the case for resolution, shadow banking and derivatives. The industry has to de-risk and change its business model. The process has been long and painful, but already the system is much safer than it was five years ago. There is still a huge amount of work required to regain the public’s trust. Basel III was the single most important element of regulatory response to the crisis. In Pittsburgh, there was a mandate which was handed down to the Basel Committee. In Europe, this was taken up in the CRD IV text. This is largely finalised but many of the implementing measures are still being discussed by the EBA. There is some national discretion in the implementation. The main elements will come into force in January next year.
There are multiple levels of decision making. The G20 is a global, political forum which meets irregularly. The Basel Committee is a technical body with a global mandate. It comprises senior, unelected officials from the central banks and treasuries of the world’s largest economies. The EU has both political and technical bodies to supervise the procedure. So far, so complicated. However, imperfect decision-making structures lead to a lack of consistency or compliance in enforcement. Some countries are yet to implement Basel III. Governor Mark Carney named and shamed Indonesia in the public letter in September.
However, even in the implementation process, there are large national discrepancies: Switzerland has stricter capital rules for domestic banks. The US has imposed standalone capital and liquidity rules on foreign banks in its jurisdiction. The UK Government implemented the ringfence suggested by John Vickers and the EU is looking at Liikanen. Is this democratising the reform process or is this democracy getting too involved? It is the industry’s view that there are widely different standards which could increase costs and present serious operational challenges. However, the Basel model provides interesting safeguards and attempting to prevent countries from engaging in a race to the bottom. The Basel process exemplifies the key tensions among reformers. The fundamental tension is between the desire for strong, effective global rules and the reasonable demand by governments and citizens for diversity, safety and control at national level. This challenge will remain for the coming years.
Professor Walter Mattli asked what lessons can the history of regulation can teach. Reform is always reactive, never proactive. Effective regulatory change is relatively rare. Even successful cases tend to be highly protracted affairs; some taking multiple years. Regulatory change produces winners and losers and potential losers will fight at every stage of the reform process. Some potential losers are economically very strong. The financial sector is dominant part of the economy, but economic dominance must not become politically dominant. Such an outcome must be avoided. Failure can be avoided by invigorating both institutional checks and balances and political checks and balances. This means fair and equal access as early as the agenda setting stage for all stakeholders. The Commission is said to be so ‘over-lobbied’ by stakeholders that it often closes the door on the little people. There are interesting solutions provided in proxy advocacy and trilateralism. The financial industry is not homogenous. One recommendation is for public officials to support ‘matchmaking schemes’ that enable a more balanced interest representation. This is true for all policy areas but a fortiori for financial services.
Robert Jenkins said that this currently is the greatest credit bubble in history. Bubbles always feature greed, stupidity and leverage. The most recent bubble has a stronger component of excessive leverage than previous bubbles. The former two problems cannot be addressed, but leverage ratios have to be addressed. There may or may not be progress on Basel III but Basel III does not make any significant reduction of excessive leverage. The risk-weighted asset approach is gamed and manipulated or the subject of misjudgement. Even if the Basel standard risk weights were applied, there would still be a dependence on the judgement of the regulators. Regulators are not infallible: they got it wrong last time round. Basel II required little loss absorbing capital: 40c for every €100 of CDO-squared exposure. Basel III requires €1.33 for every €100 of exposure. On leverage ratio, he said that the new Basel rules will enshrine a permission to borrow for every €100 of balance sheet to fund it with €97 of borrowing, with only €3 of loss-absorbing equity. He does not think this is progress.
Sharon Bowles MEP said that there is a regulatory political gap. This is about democracy. As a result of the financial crisis, many members of parliaments throughout Europe lost their seats and governments fell. The regulators, who had been making the rules leading up to the crisis, do not seem to have fallen in large numbers. Therefore, can it be right to have everything regulated in a technical committee without accountability? There was G20, a political process, then the technical process in Basel. In Europe, in order to make it work, politics has to enact the law towards the end of the process. Then, at this late stage, politicians fiddle around with the suggestions. She is pleased she influenced the rules on risk-weighting and trade finance because she thinks it was the right thing to do. Basel was too strict. The Basel apparatus is trying to make sure that everybody does everything exactly the same. However, countries are not all the same. There were a lot of mistakes made by the Basel Committee. Some of their suggestions just do not work unless you have the active CDS market that used to exist in the US. It does not work in Europe.
From time to time, somebody needs to stick their neck out and talk about it. The G20 made everything worse unintentionally. What they should have done, is to look at how to resolve a bank. There was ‘too-big-to-fail’, banks were going under, but nobody thought how to resolve a bank. That then, would have led to a lot more sensible approach to ringfencing and capital requirements. Resolution should not have been the first sign. It was a tick-box approach to ‘how many pieces of legislation have you done?’.
In Parliament, things moved so fast that important discussions disappear into shadows meetings and in the opacity of trilogues. It’s a serious problem. It is not right to say lobbying is the problem. The Parliament is good at listening to the consumers. If there is a bias, it is in favour consumers. She thinks we are where we are because the regulators have made things too complicated. Of course, rules are being gamed. The risk weights is nothing to do with the banks; it’s politics. There should be a corporate governance buffer, that financial institutions don’t think it’s in their best interest to game the rules. The US has managed to scare banks into obedience with the suspended prosecutions. If they transgress, they get punished. She thinks Europe should think to do this. The risk of transgression is so big that you don’t want to do it.
Kuttner said that the regulators did take the fall but the financial system has evolved to be too complicated to be regulated. He wonders whether there is something inherently anti-democratic in the complexity of modern finance, compounded by the fact that global regulation has to do without democratic accountability to regular people.
Lewis said that the G20 principles were robust and sound. They were applied in Europe and the US. In 2009, not much thought went into how the application would work in different countries. Yes, regulators talk and coordinate. Yes, there is political will, but somewhere between national and supranational legislation there is a piece missing. He wonders whether there is a role to play for IOSCO.
Professor Mattli said that there is a lot of complexity in all sorts of regulation, if you want to really understand the issues you need good, expert rules. The difficulty is to draw in other society stakeholders. This is largely a national process and some states have been more successful at this than others.
Kuttner said that under Glass-Steagall, definitions were simple.
Bowles said that simpler is better. If you don’t understand it it shouldn’t be allowed to happen. Accounting standards are another problem. There are balance sheets that are difficult to understand and accounting standards that list future gains at the present. This creates the need for a credit bubble. Auditors don’t want the liability. This is wrong. Ultimately, someone has to take liability.
Jenkins said that you can either fight the regulation or fight the system. You could argue that regulation is a response to the fact that the question about the structure has been avoided thus far. Lobbying has convinced policymakers that society has to choose between safety and growth, safety of banks and shareholder value and between a safe banking system and a competitive financial market place. This has been propagated so effectively to defeat the point of reform. When a bank has a €1trn balance sheet, funded with €50bn of equity and €950bn of debt. Now regulators ask to double the equity to €100bn and reduce the debt by €50bn. Does this shrink the balance sheet? – No. Have you had to cut back on credit? – No. Has society had to choose between safety and growth? No. But banks have persuaded everyone that cutting back on credit will be a consequence of safer banks. This brings politicians in an awkward position.
The second apparent choice is between shareholder value and safer banks. If you define profitability and shareholder value in terms of return on equity, this could indeed be a choice. Banks targeted double digit return on equity. Was that a good measure of profitability? Did that produce sustainable shareholder value? Certainly, less equity with a same return produces higher return on equity. However, as Sheila Bair said, the four largest banks did not do very well for their shareholders. Return on equity, for a long time, was very high. The problem with the return on equity is that it does not adjust for risk. The returns come down, and the related bonuses, but the risks come later, in the next crisis. Moreover, investors are also getting smarter, they are interested in risk-adjusted return on equity and therefore buy gilts. They accept the lower yield, in exchange for lower risk. The more risk in the balance sheet, the more the return the investor will require. The less risk in the balance sheet, the lower the return the investor will require. Capital will flow in either case, but the cost will be different. The risk-adjusted return will be the same. Banks can have lower ROE with lower risk, and produce the same shareholder value with a higher multiple. You do not have to choose between safety and value.
And finally, why wouldn’t a safe, stable system be less attractive to investors than an unstable one.
Lewis said that the issue of bank lending in Europe is that there is an over-reliance on bank lending in Europe and people want other sources of finance. The capital markets in Europe have to open up to enable businesses to be funded in the sorts of ways they are funded in the US. There may be a perception that businesses are not funded through banks, but the reality is that there is an over-reliance on bank financing. This will require flexible and fast-moving markets. Economic growth can only come through open markets.
Jenkins agrees this would be desirable and acknowledges that Europe is more dependent on bank lending than on securitisation. However, a more highly capitalised banking system in Europe would have been able to take the hit and would have been able to carry on financing the economy. Banks that are more capitalised can take the hit and keep lending.
Kuttner said that there is a need for open capital markets but because of the fiscal situation there is less potential of commercial lending. There is co-dependency between dysfunctional banks and dysfunctional states. This leads states to look less closely at banks’ balance sheets for fear of what they might find.
Bowles said that the bank resolution and recovery programme is trying to address this. Of course, if push comes to shove, states are likely to get involved if things get really bad, but a lot of damage will be absorbed before they wade in. Proper application of state aid rules can also help. Of course, zero risk-weighting of sovereign debt would help, but she has tried to suggest this unsuccessfully for a long time. Politically, it’s at an impasse. There is still a notion to get the same treatment for every state. She is not optimistic that you can actually really break the nexus, but bank resolution and recovery, making sure you have more equity and other things can rebalance the system. It will be a long haul.
Lewis said that the Banking Union is the biggest potential structural change in a long time. It will be a major step forward. It will require a lot of political will to implement something like that.
Jenkins replied to a question about ethics. In order for ethics to play a bigger role, consumers have to be higher up the stakeholder pecking order. If you move the customer up, if your corporate motto is ‘Do what’s right for the customer and the customer will do what’s right for your company’, ethics can become more important. The reverse question is whether you can move the customer up the stakeholder pecking order without damaging the shareholder? Provided you are willing to measure success over a longer term basis. If you present a compelling enough proposition, the market will attach a higher multiple to that company. Jenkins thinks that ethics can be more important.
Kuttner said that a market where the consumer comes last is a failed market.
Jenkins said that putting some people in jail could hammer home the reform. The Financial Services Authority, now the Financial Conduct Authority, seemed powerless to hold individuals liable, but they have a process of authorising persons. So they could have withdrawn the authorisation for all the directors of all the banks that failed, somebody has to have the courage to act.
Bowles said that anything on criminal sanctions falls under Member State authority. It is aggravating for the Parliament.
Responding to a question on lobbying, Professor Mattli asked why so many people with knowledge are not entitled to be involved in the policy process. There needs to be transparency. He is hugely impressed with Gary Gensler’s proposal to publish summaries of every meeting that takes place. There is so much more work to be done. Transparency on lobbying needs to be enforced much more strongly. He criticised IASB. The Board is largely made up of non-European representing European interests. Stakeholders also need to be educated about the processes.
Lewis said that there is a lot of misunderstanding about how dossiers move in Brussels. Maybe this will never be perfectly transparent, but there is a challenge to make it a little clearer.
Jenkins said that in the US, a number of Congressmen wanted to raise capital levels. Their mission gained momentum when they got the community banks involved. No part of the financial sector has a greater stake in financial stability than the investment firms. Yet they are the most silent.
Bowles said that generally, rapporteurs make their documentation on lobbying public. However, there is only so much one Committee can do and the Secretariat won’t sign up to things that are not the same. She said that, as a whole Parliament is very sympathetic to consumer organisations, but she, and a number of her colleagues, have had bad experiences. In any case, she likes to have position papers ahead of the meeting. Once a dossier is in trilogue, it is too late for lobbying. It’s all political at that stage. The process are difficult, even for her, there are parts of the process that are not public.
Jenkins responded to a question on financial jargon. There should be a rule that you can’t called a ‘bank’ if not at least 51 per cent of your risks are tied up in the real economy.
Bowles responded to a question on the asset quality review. The credibility of the ECB is on the line here. There are other issues, like transparency.
Kuttner agreed that the stakes on this are uniquely high. This is not just about the financial system but about democracy.