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Charles Goodhart warns of regulatory overkill

Charles Goodhart warns of regulatory overkill Ian Fraser

In forcing the world's banks to dramatically increase their capital ratios at a time when capital is scarce, are global policymakers and regulators over-reacting to the crisis and reinforcing deflationary tendencies? And with their obsession with promoting new entrants and increased competition in the banking market, are they at risk of sowing the seeds of the next crisis? According to Charles Goodhart, emeritus professor of banking and finance at the London School of Economics, the answers are yes and yes.

Goodhart, a former Bank of England official who was a member of the Bank of England’s monetary policy committee from 1997 to 2000, has made clear that a reversion to having a myriad of small local banks whose managements had unlimited liability just would not work in contemporary society. In an article published by Central Goodhart criticized Andy Haldane, Bank of England executive director for financial stability. In particular Goodhart rubbished Haldane's view that the promotion of loads of small, "challenger" banks would somehow stabilize the financial system. Goodhart argued that it would, in fact, have the reverse effect:

"One of the main reasons why the financial system was so stable between the 1930s and the 1970s was that competition was ruthlessly suppressed. It is the 'challenger banks', the fringe banks, Northern Rock, the Icelandic banks, Anglo-Irish, the middle-sized banks, beloved of Andy Haldane, struggling to get larger, that drive the financial system so often to disaster. The countries with the most stable outcomes in the recent crisis were those with the most oligopolistic, protected from foreign competition, domestic banking markets: Australia, much of Asia, Canada, etc."

Goodhart has an annoying habit of being right. He has been pointing out flaws in the 'Basel' regime of bank capital requirements for at least a decade.

Seven years before the crisis struck, when Basel II was under development, Goodhart was already warning it had serious flaws. In a prescient September 2004 paper co-authored with Ashley Taylor (“Procyclicality and volatility in the financial system"), he warned that combination of the Basel II capital rules and 'fair value’ or IAS 39 accounting would prove disastrous for western economies. Taylor and Goodhart wrote:

“Whilst procyclicality has not been as dominant a feature within the debate over IAS 39 as it has in Basel II, there does nevertheless appear to be the potential for such effects. During economic downturns falls in asset prices may feed through to either the profit or loss account or equity levels, which may have knock-on effects on lending which could exacerbate the downturn.”

This and earlier warnings from Goodhart fell on deaf ears in Basel. But Goodhart is not giving up. In a speech given at London’s Gresham College on March 1 (summarized in a bylined article for City A.M.), in which he took the long view of the ebb and flow of financial regulation from the outh Sea Bubble of 1720 to the present day, Goodhart criticized policymakers and regulators for their tendency to over-react to busts.

He said that once it becomes apparent that their tight post-crisis regulatory regime is stultifying growth, regulators tend to gradually release the brakes and a deregulatory free for all or “race to the bottom” invariably ensues – whereupon the whole cycle repeats itself. He also said the unthinkable. That the over-riding global regulatory response to the response, agreed at the G20's Pittsburgh summit in September 2009 – to impose much tougher capital ratios on banks – is misguided. He wrote:

"After a crisis has occurred, the immediate, inherent response is “that must never be allowed to happen again”… Regulatory equity requirements have gone from around 2% or less of risk-weighted assets in 2007 to 9% by June 2012. Liquidity requirements, the liquidity coverage ratio and net stable funding ratio, are following along… [this] is one of the more important factors behind the current massive deleveraging in European banks. Many such as RBS are now cutting their balance sheets almost as aggressively as they expanded them before 2008; and both tendencies will have aggravated the cycle.

Does it matter? If you are a monetarist, it certainly does. Less so if one focuses on bank credit, because a shift from deposits to capital should have relatively little effect, even perhaps positive – for example, reducing zombie loans and increasing loans for new, better enterprises. Nevertheless it is hardly to be recommended."

Goodhart outlined better ways for policymakers, regulators and the Basel committee to tackle the thorny problem of ‘procyclicality’. He wrote:

"Basel I and II requirements actually worsened the use of equity as a buffer against unexpected losses for a going concern. Bank managers focus on return on equity, because they answer to shareholders. Capital adequacy requirements make achievement of a high return on equity more difficult. Bank managers therefore responded by lowering the quality of CAR capital, increasing leverage relative to risk-weighted assets and reducing the buffer above the minimum required CAR.

We need a new approach to ratio controls. Instead of one ratio, two. A much lower ratio where a bank becomes too dangerous to allow management to continue, and a much higher, fully satisfactory level. The two need to be connected by a ladder of sanctions, mild to begin with, more severe as we move towards closure point."

Goodhart said that penalties should include ‘charges’ for milder shortfalls, with enforced clamp downs on payouts including dividends, buy-backs and bonuses for more serious transgressions.

Equity shareholders, with limited liability, share the same incentives to take on extra risk as the managers have, with a limited downside and unlimited upside potential. As the market value of equity falls, more of the potential (tail) risk of absorbing losses falls onto bond-holders and/or taxpayers. The need then is to find a way to transfer governance and control to such other risk-bearers increasingly as equity values fall.

The call for Co-Cos and bail-in-able bonds goes some way in this direction, but there can be contagion problems. There should be a much greater willingness to embrace taking weak financial intermediaries into temporary public ownership, if and when necessary, before they have completely crashed into the rocks of bankruptcy.

I'm with Goodhart on some but not all of this. I definitely agree with his idea that that the best way of dealing with the perverse risk-taking incentives provided by limited liability status is to gradually shift responsibility for governance and ownership away from shareholders (and their appointees – bank board directors), onto bondholders and then onto the government as a bank errs towards greater riskiness.

Further reading on bank regulation and reform:

Tags: Andy Haldane , Ashley Taylor , Bank for International Settlements , banking , Basel Committee on Banking Supervision , Basel II , Basel III , bonds , capital adequacy requirements , Charles Goodhart , City A.M. , Co-Cos , deregulation , fair value , Gresham College , IAS 39 , IFRS , limited liability , London School of Economics , Northern Rock , procyclical , procyclicality , regulation , return on equity , unlimited liability
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