London Guardian-Observer - Book Review

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The Guardian/The Observer – 4/13/2013

Unless The Banks Are Sound, Our Economy Never Will Be – A Radical New Book That Our Banks Still Aren’t Holding Enough Capital To Prevent Another Financial Crisis
By Heather Stewart, The Observer


Poor Sir James Crosby – as we must still call him, despite his wish to be plain mister – must now get by on a pension of just £406,000, after conceding last week that he should bear his share of the responsibility for the collapse of HBOS.

His outbreak of humility, following the strongly worded report by the parliamentary commission on banking standards into the bailed-out bank's demise, was another step towards the public catharsis Britain has so far failed to achieve in the wake of the financial meltdown of 2008-09.

Andrew Tyrie's commission, which boasts former chancellor Lord Lawson and no lesser figure than the Archbishop of Canterbury among its members, has done great work in peeling back the layers of self-justification and myth-making that had allowed some of the key protagonists in Britain's catastrophic banking crisis to insist that their consciences were clear.

But the danger of such clear-cut historical analysis is that it consigns the recklessness and risk that brought down HBOS to the past. In a thought-provoking new book, The Bankers' New Clothes, described by the FT's Martin Wolf as the most important to emerge from the crisis, Anat Admati and Martin Hellwig make the heretical argument that banks are holding far too little capital, and this makes a fresh financial crisis is all but inevitable.

One former Labour cabinet minister remarked wistfully after Crosby's climbdown last week that it was rather a shame, because while HBOS chairman Lord Stevenson, HBOS's chairman, who was also castigated by the committee, had never given much impression of being a banking expert, Crosby "really seemed to know what he was talking about".

Labour heavyweights were far from alone in being taken in. The mystique of the money men, with their mathematical models and beautifully tailored suits, convinced everyone, including their own regulators, that they knew what they were doing.

Today, they are busy modelling another suit of what Admati and Hellwig call "new clothes" – this time the idea that they can't possibly raise new capital from their shareholders without threatening to bring the fledgling economic recovery to a halt.

Most fundamentally, the authors insist that boosting capital levels need not curb lending. Because capital is new funding, raised from shareholders or by reinvesting a bank's profits, it doesn't have to sit idle in a vault, but can be lent out. The question of how much lending to do is a separate one.

Since the start of the credit crisis, we've all been forced to think hard about the ways in which banks are different from other businesses, not least because of the damaging knock-on effects of a banking collapse on the rest of the economy, and on taxpayers.

But Admati and Hellwig insist that they're also fundamentally similar to other firms (and indeed homeowners), in a key sense: the more equity they have, the safer they become.

Banks overwhelmingly fund themselves with debt, with borrowing levels far higher than most shareholders would consider prudent for other firms. That's for a patchwork of reasons, not least the fact that banks' creditors assume they will be bailed out in the event of a collapse, so are willing to lend to them cheaply.

But just as a widget-maker, or a homeowner, would be considered dangerously leveraged if they had equity in their company or their home worth just 3-4% of its total value, banks' heavy dependence on debt makes them extremely vulnerable to even small fluctuations in the value of their assets, however sophisticated their risk models. That thin sliver of shareholders' capital is wiped out all too easily.

Admati and Hellwig argue that capital levels should routinely be much higher – perhaps 20% to 30% of banks' total funding, instead of less than 5%. If, they say, a bank is unable to raise new capital – by retaining profits or by issuing new shares at any price – it would be a market signal that it was at risk of insolvency, and should be carefully dismantled, instead of kept alive by artificially cheap debt.

For the UK, where even after the crash the financial industry is cherished, that would be a very bold upending of the long-held logic – accepted by George Osborne when he watered down the Vickers report proposals on banks' leverage levels – that forcing banks to build up capital is tantamount to telling them not to lend.

But it should also embolden the Bank of England's financial policy committee, which has been widely criticised for asking the banks to find an extra £25bn; and the commission for banking standards – which has already scored a considerable achievement in persuading the chancellor to "electrify" the ringfence between banks' investment banking and high street operations. Admati and Hellwig argue powerfully that if banks' funding model looks shaky, that's because it is.

There is growing evidence that, outside the Treasury at least, policymakers are starting to think more radically too. The Bank of England's Andy Haldane has suggested that a clear, simple rule forcing banks to hold more capital might be more powerful and effective than the internationally agreed Basel III framework, with its fearsomely complex "risk-weightings" for different investments.

As Haldane put it in a characteristically metaphor-rich speech last week, "thin-slicing reform, whether regulation or tax, condemns us to failure. Peeling the onion one layer at a time tends to end in tears. It is only by removing all of the old layers that the painter and decorator can achieve a robust finish."

Bankers and politicians have plenty of reasons for maintaining the status quo that has prevailed since the crisis, but Tyrie should not be afraid to get out the paint-stripper.