Wednesday, 28 May 2014

Bank Capital and Financial Instability

Robert Jenkins, who recently served on the Financial Policy Committee of the Bank of England and a current member of the Board of Governors of CFA Institute, writes (my bold):
The banking system freezes when losses threaten to overwhelm banks’ loss-taking ability. And their loss-taking ability is determined by the degree to which their risk taking is funded with equity versus debt. In other words, financial stability hinges on the amount of capital in bank balance sheets. Going into the recent crisis, most of the world’s largest, complex, and interconnected banks were excessively leveraged. Loss-absorbing capital was wafer thin. Not surprisingly, market confidence evaporated quickly.
What is surprising is that regulators have failed to embrace the lessons of the debacle. Leverage remains excessive. Yes, new global standards have been agreed upon in Basel. They tighten definitions of banking risk and place an overall cap on leverage. But as currently set, the rules permit the balance sheets of banks to balloon to 33 times their equity. At that level, bank asset values need fall only 3% to wipe out 100% of capital. A mere 1% drop leaves the institutions geared 50 times; a 2% fall, 100 times. How confidence inspiring is that? At the next sign of stress, how long do you suppose bank creditors will wait around to find out? How long will you wait? Now consider that some banks’ balance sheets are equal in size to their home nations’ GDP and you will grasp central bankers’ admission that we have yet to eliminate the problem of too big to fail. How can this be? Might bank lobbying explain it?
Read the full article here.

The chart below partly shows what Mr Jenkins talks about, namely the overall equity to total asset ratio for U.S. Commercial Banks. For the week ending 10 September 2008 (just prior to the Lehman bust) the ratio stood at 10.62%. Today, more than 5 years and 8 months later, this ratio is now 10.84%, a mere 22 basis points higher. In other words, "financial stability" is just as unstable today as it was before the inevitable collapse in September 2008 on this measure.

Add the fact that the U.S. federal debt to GDP ratio has risen from 67.5% in Q3 2008 to 102.6% in Q1 2014 and the cocktail has been mixed to unleash future financial instability once again. I'm in the camp that has concluded that the next bust will be much, much worse than 2008. Much worse.