Distorting the market

Citation

Cookson, R. (2000), "Distorting the market", Balance Sheet, Vol. 8 No. 5. https://doi.org/10.1108/bs.2000.26508eaf.001

Distorting the market

Richard Cookson

Banks, we all know, will always find ways to lose money. It is the nature of the beast. Regulators will always try to stop them. Unfortunately, they also try and mitigate the effects on savers and on other banks that a bank's collapse would entail. That generally means either of or a combination of two things: a system of deposit insurance and a policy of not letting very big banks go under.

You might notice that there is in this admirable aim a contradiction. If big banks (and their depositors and shareholders) are bailed out when they get into trouble, there is little incentive for them to keep a tight rein on their risks. Quite the opposite in fact: what is there to lose by taking lots of risks? In the jargon, this is called moral hazard; in everybody else's terms, heads-I-win-tails-you-lose. This has always been true; but the development of marvellously sophisticated financial markets makes it ever easier to take these risks and shift them around both the institution and, for really big banks, the world.

So the question is this: how can regulators contain banks' worst excesses? One answer, of course, is to make them keep a certain amount of capital against their risky assets, so that, if they do get into trouble, they have a cushion to stop them going bust. This, in essence, is the approach taken by the Basel Accord. Adopted in 1988, this demands, very roughly, that banks must have capital equivalent to 8 per cent of their risky assets.

Although that seems sensible enough, in fact the original accord may have done more harm than good. It was, for a start, full of holes. Japanese banks, for example, could count unrealised gains on equity for almost half of their tier-two equity, which, as we all know now, left them rather exposed when the Nikkei fell to earth. But it also provided completely the wrong incentives for banks' lending practices. Take one, slightly worn, example. Banks have to put aside exactly the same capital against lending to General Electric as they do to the most fly-by-night technology company. Since they are likely to earn better returns on the latter for the same capital, guess who they are more likely to want to lend to?

And the ability of banks to game the system has grown hugely, thanks to whizzy advances in financial theory and even whizzier advances in technology. Securitisation provides a good example. It looks great on paper: rather than keep loans on their balance-sheets, they securitise them into different bundles of risk, and sell them to those more willing to take that risk. Banks appear, therefore, to be removing risk from their balance-sheets, and less capital is demanded from regulators. Whether they are, in fact, removing any risk at all from their balance-sheets is a moot point. Often, banks keep the most toxic stuff on their books. In theory, this should be completely written off against capital; in practice, who knows?

The present accord junks accurate risk assessment for simplicity. So lending to an OECD country or a company in it, for example, carries a lower capital charge than lending to a country that is not in it. But since both South Korea and America are members of the OECD, this clearly has little relation to the actual risks run.

So the fundamental problem of the accord as it presently stands is quite simple: the amount of capital that banks have to put aside is not accurately calibrated to the risks that they run. Where they have to put more capital aside than they think economically justified, they will be loath to do the business and vice versa. Unfortunately, the solution to this problem is anything but simple ­ something that the good folk who are trying to revise the accord are finding out.

The question they are now wrestling with ­ and remember that they have to get agreement between all of the countries concerned ­ is how to find an acceptable way of measuring the risks that banks run that is comparable between banks in different countries. Their first wheeze sounded fine in practice: use external credit-rating agencies. The catch was that everybody hated it, the rating agencies not least. Apart from in America, few companies have ratings. Many felt that American banks would therefore have an advantage. The partial solution made something of a mockery of the original aims: lending to unrated companies would attract a lower capital requirement than lowly rated ones.

Doubtless, some form of capital charges based on external ratings will emerge, but no bank worth its salt would use it. The big, sophisticated banks want to use internal models. Rightly, regulators thought that these were insufficiently tested. So now the Basle committee and its various sub-committees are instead turning to internal ratings as a decent halfway house.

But using banks' internal ratings is a daunting task as well. How to tie them to capital standards? How to compare one bank's with another's, especially if they are in different countries? Should banks that use internal ratings, which are presumably more sophisticated, have to hold less capital than those that use the external ratings approach? And if the answer to that is "yes", then will that give the former an overwhelming competitive advantage? Who will say whether one lot of ratings is good and another bad? Supervisors, presumably. But that will mean much more supervisory interference, which in turn means greater regulatory costs.

All in all, you cannot help feeling that there must be a better way of trying to stop banks from their worst excesses. One way, suggested by some academics, is, roughly, to force banks to issue lots of capital in the form of subordinated debt. If the yields on this debt rose above a certain pre-determined level, then banks would have to reduce their risks. This has the advantage of being a more market-orientated solution. Regulators argue, however, that it is often difficult to separate the noise in debt markets from what is going on in banks' underlying businesses.

Short of withdrawing all guarantees, either explicit or implicit, which would be politically tough and, in the case of the biggest banks, systemically problematic, to say the least, it looks as if taxpayers will continue to pick up the pieces for a long time yet.

Richard Cookson is banking and markets editor for The Economist.