The problem with banking on the future

The terrible tragedy is that the banking world hasn’t learned from the GFC, and it doesn’t even know it yet, OECD special advisor Adrian Blundell-Wignall explains to Adam Creighton 

It is more than five years since the United States Federal Reserve cobbled together a rescue plan for the former Wall Street investment firm Bear Stearns. Only a few months later an even bigger banking titan, Lehman Brothers, filed for bankruptcy, paralysing financial markets from London to Sydney. Soon even good banks were too fearful to lend to one another, and governments from Ireland, to the United States to Australia were compelled to intervene to protect their biggest financial institutions from becoming insolvent. 

The global financial crisis prompted the biggest economic downturn since the Great Depression, throwing millions of people onto the unemployment heap and burdening future generations with debts so great, many wonder whether they will ever be repaid. This year economists are arguing about the pace of the economic recovery, but some are deeply concerned the lessons of 2008 were never adequately learned, and the world is headed for another, even worse, financial crisis. 

Adrian Blundell-Wignall is one of Australia’s most successful economic exports. He grew up in Perth, worked as an economist for the Reserve Bank in Sydney, and obtained a PhD in economics at Cambridge University, one of the intellectual cradles of modern economics. He now works in Paris as special adviser to the OECD’s secretarygeneral for financial issues, and is not afraid to speak his mind. 

Too little capital 

In his recent visits to Sydney, including his insightful – and controversial – presentation at the Institute of Chartered Accountants Australia’s Business Forum, Blundell-Wignall argued strongly that the adam creighton is the economics correspondent for The Australian. He was formerly senior adviser to the Leader of the Opposition and has written for The Economist and The Spectator. world’s biggest banks continue to hold far too little capital but that regulators, many of whom agree with him privately, are unwilling to do much about it because of the political and financial clout of the finance sector. 

Stressing that Australia’s big banks are sound, relative to their global US and European peers, the former Reserve Bank official argues that unweighted capital ratios are still far too low and that the new global banking accord, known as Basel III, is, in effect, toothless. 

Since the late 1980s, bank regulators in advanced countries have agreed that banks should carry capital equivalent to 8 per cent of their ‘risk-weighted assets’, which means assets that are perceived as less risky such as government bonds or good quality mortgages are multiplied by a factor of 0.2, or even zero, before the asset ratios are calculated. This practice has proven very problematic in Europe in recent years, where Greek government bonds, for instance, were discounted heavily even though they turned out to be near worthless. 

“Banks use their internal models to reduce their risk-weighted assets, which leaves them massively leveraged,” Blundell-Wignall says. For example, in Australia the Commonwealth Bank and National Australia Bank each have official ‘capital ratios’ near 10 per cent, but their real ratios as of March this year were around 5.8 per cent each. For many of the world’s largest banks, the equivalent unweighted ratio is far lower. 

The OECD is calling for a simple 5 per cent minimum unweighted capital ratio for all banks worldwide. Even this is generous: banks’ assets would need to fall only 5 per cent for them to be insolvent. The new Basel III regime, which will be rolled out in most countries by 2016, will lift capital standards a little but most banks will still fall far short of even this ratio. 

Some countries are going further. Blundell-Wignall contributed to Britain’s Independent Commission on Banking. The Commission recommended, and the British government largely accepted, that ordinary retail banks should hold capital up to 17 per cent of assets. Switzerland and Sweden are forcing their biggest banks to have capital ratios near 20 per cent. 

“Before the GFC, many thought hedge funds and private equity firms – the unregulated parts of the financial sector – would be the cause of any crisis, when in fact it was the regulated sector that caused the trouble,” Blundell-Wignall says. 

Banks are quick to argue that even higher capital ratios would damage economic growth. “The biggest banks do very little lending to real businesses anyway, and besides, Wells Fargo, a big US bank, is only 13 times leveraged yet still lending and profitable,” Blundell- Wignall says. 

Too big to fail 

Tighter capital ratios do not mean banks inevitably lend less. Holding more capital does not imply that a greater pile of cash is to sit in bank vaults and not contribute to lending. Tighter ratios only affect how a bank’s assets are financed, requiring that a greater share come from shareholders rather than lenders. But it is more expensive to finance loans through equity rather than debt. 

Blundell-Wignall says banks’ lobbying efforts are immense, and regulators are “captured” by the finance industry. “Apparently, we need to have a bigger crisis before we finally get the reforms we need,” he says sardonically. 

The British Banking Commission also recommended investment banks be split from retail banks, which Blundell-Wignall believes should occur in Australia too. “Assets, liabilities and capital should not be able to shift among the trading and retail arms of banks,” he says. 

Since the GFC, regulators worldwide have sought to limit big banks’ ability to trade derivatives, and scrutinised their investment banking activities, which are thought to be riskier and hence more likely to require taxpayer bailouts. 

“This would not be such a big deal for the big four Australian banks because the European and American banks, which arrived en masse in the 1980s and 1990s, tend to monopolise those lines of business in Australia,” he says. 

Blundell-Wignall believes the massive growth in derivatives in the lead-up to the GFC reflected a damaging misallocation of capital. Only a small fraction of derivatives are trades between banks and real companies, most are speculative arrangements among banks themselves. 

“We need to increase the cost of capital for transactions like these by preventing banks that are too big to fail from benefiting from them at the potential cost of taxpayers” he says. 

Cause and solution 

One of the great ironies of the GFC is that one of the main causes – unsustainably low interest rates – is also cast as the solution. The Federal Reserve in the US, the European Central Bank and, now especially, the Bank of Japan are not only holding interest rates low but also boosting the supply of money. The official explanation is extra money will encourage banks to lend more, and thereby help revive moribund economies, but ‘quantitative easing’ (QE) also has the added benefit of depreciating currencies and making local exports more competitive. 

Blundell-Wignall worries such ‘beggarthy- neighbour’ policies are dragging the world, and a reluctant Australia, into an internecine global currency war. “Australia is in a very unfortunate position,” he says. “Having done the right thing, having no capital controls, Australia is now facing the whole avalanche of world investors seeking out Australian assets.” 

Despite a sizeable fall in May, the Australian dollar has traded far above what most economists believe justified by fundamental economic conditions. Investors have sought out Australian assets because of uncertainty about QE in Europe and the United States, and because interest rates – and investment opportunities – are greater here than in comparable countries. 

The Reserve Bank cut interest rates to an historic low of 2.75 per cent in May, which most commentators believed was motivated, at least in part, to discourage global investors from parking their funds here. Lowering interest rates too much for too long can encourage speculative borrowing and asset price bubbles that cause major economic damage when they ultimately collapse. 

Potentially bankrupt 

The bond market is a good example right now. QE has created a gigantic bubble in bond prices, whose bursting would cause enormous damage, Blundell-Wignall argues. Bond prices are only high (and interest rates, conversely, low) because central banks are buying bonds with newly created money. When that stops, let alone reverses, yields will rise and prices will fall, potentially bankrupting bond investors and making it much harder for indebted western governments to service their debts. 

“The idea we can have free or cheap money forever is ridiculous,” Blundell- Wignall says, arguing QE had helped restore global banks to profitability without fixing serious flaws in the global banking system. 

His prognosis for Europe is dire because of the strong political attachment to keeping the euro area together. “The south (of Europe) is being absolutely cremated,” Blundell-Wignall says, noting youth unemployment in Spain and Greece, for whom the euro is an economic straitjacket, is now around 57 per cent. 

He predicts widespread emigration from southern Europe in much the same way the Irish left Ireland during the 100-year currency union from 1820 with Britain, which was a much richer country in the way Germany, the Netherlands and France are today. 

“The north of Europe, which exports high-end capital goods, is doing fine, but the southern manufacturers cannot compete with Asian countries,” he says, suggesting weaker currency would be a much easier way for them to adjust to this economic reality. 

Adam Creighton is the economics correspondent for The Australian. He was formerly senior adviser to the Leader of the Opposition and has written for The Economist and The Spectator.

Article last updated 1 August 2013