Change in the bank

In an article last week I examined a case advanced by Andrew Haldane, a Bank of England economist, in a recent speech, that modern bankers had become insulated from the risks of banking and incentivised to seek out high returns through indulging in risky investment strategies. Recently the Bank of England’s Financial Policy Committee published a statement from its March 16 policy meeting where it noted that “the capital [of banks] was not yet at levels that would ensure resilience in the face of prospective risks...” before recommending that that banks seek to raise external capital.

Banks should be funded through higher levels of equity capital- Piers Allen

They also suggested that “conditions remain fragile” and that “questions remained about the indebtedness and competitiveness of some European countries.” The point was made that banks with particular exposure to those countries should make particular efforts to increase their capital levels. The question is then, what should banks be doing about these problems.

Again we can look to Mr Haldane’s speech for some suggestions. Firstly banks should be funded through higher levels of equity capital. This point is probably unsurprising since the primary font of international standards on banking matters is the Basel Committee on Banking Supervision, and their policy response to the financial crisis of the late 2000s was called Basel III. Basel III requires that by 2019 banks should have a common equity ratio of seven per cent and 8.5 per cent for Tier 1 capital.

This measure would also leave investors more exposed and hence focus their attentions more fully on the responsible management of the bank. Business taxation could also be restructured such that the costs of debt are adequately balanced against those of equity, perhaps either by permitting firms to offset equity costs from profits, or alternatively by limiting the offsetting of debt interest against profits.

Secondly the suggestion is that banks could be funded using “equity-like” liabilities such as “contingent convertible securities” (or “co-cos” in the jargon). These peculiar financial instruments combine the attributes of both debt and equity, converting between each depending on the market conditions. During periods of stability they would be treated as debt, but as equity during times of market duress, and so could help to moderate the distorting effect of the limited liability/unlimited upside nature of equity.

Co-cos are innovative instruments and quite the extent to which they might help a bank in distress is a little open to debate. However since, in the case of a bank becoming insolvent, holders of these instruments would be reimbursed only after bank depositors and conventional debt holders (but before shareholders), and further, since they pay a fixed return (as opposed to the unlimited upside of equity), co-cos could be an interesting way to incentivise banks’ management in a way that doesn’t encourage risk taking.

One of the more extreme suggestions made by the Bank of England, in order to restrain excessive risk taking, is to modify bank governance directly by extending voting rights in banks and building societies to include debt-holders (with votes weighted to some degree). Alternatively, another measure suggested would be to swap from “return-on-equity” to “return-on-assets” for the purposes of evaluating bonuses and performing financial planning, which would have a similar effect of restricting the risk seeking tendencies of bank managers and owners.

Paul Tucker, another Bank of England economist makes a similar point about reforming how management is compensated suggesting that management be rewarded with subordinated debt, instead of equity. He also argues that reforms to banking regulation should seek to have creditors bear the risk of bank failure. This will mean unsecured and uninsured creditors take losses, along with holders of bank paper (including bonds).

The argument then goes that credit analysts will need to gain the same profile and expertise in evaluating risk as equity analysts currently hold. (Indeed one of the glaring questions from Europe’s present predicament is how exactly French and German bankers ever allowed themselves to lend as much money as they did to the clearly profligate Greeks, but that is perhaps another story.)

When the social consequences of bank failure are potentially so substantial it is important that the public understands, encourages and endorses the ideas being discussed and the measures implemented to moderate the risks of the banking sector.

Luckily the regulators are already having that discussion as to what needs changing, and it just remains for us to participate in that conversation. However, we should perhaps have a little sympathy for the bankers. As Britain’s Business Secretary Vince Cable explains “... we are telling them [the banks] to do two contradictory things – rebuild their balance sheets on the one hand, and increase their lending on the other.”

Mr Allen has worked internationally in the technology sector, earning his first masters qualification in engineering from the University of Durham. For his second masters (in business administration, again from Durham) he researched the Maltese financial sector.