Fragile by design
Banks are fragile by design*. They have lots of debt, equity is only a fraction of total assets, depositors can withdraw their money on the drop of a hat. If depositors want their money back then there is a first-come-first-served rule, which differs from non-bank, corporate (orderly) bankruptcy, where creditors know their place in the queue: senior creditors are served first, junior creditors last.
Fragility and moral hazard
The designed fragility should discipline bank managers, deter them from taking risks with your money. High levels of debt (or high leverage) should incentivise creditors to monitor bank managers. The first-come-first-served rule for depositors relies on nerdy bank-watchers to run first, which should scare bankers because no bank manager wants a run. In short, the fragility is there to curb bankers’ moral hazard behaviour.
Then there is bank regulation, which further curbs moral hazard behaviour. Capital and liquidity requirements, stress tests, and resolution regulation protect society from the fallout of rogue bank managers and poor lending standards.
Financial stability now more important than moral hazard
Looking at my twitter feed I can safely conclude these are exceptional times. Consequently, the paradigm of fragility, leverage, monitoring, and curbing moral hazard has become largely irrelevant. COVID-19 is an external shock and any bank lending that goes sour because of this pandemic is unlikely the result of risk-taking or moral hazard behaviour.
As a result, the tools that rely on built-in fragility are an obstacle now. Leverage, monitoring, the first-come-first-requirement for depositors. These are meant to deter moral hazard behaviour, but moral hazard is a non-issue now. What is relevant now: maintaining financial stability.
So, yes, it is no surprise that last week, bank regulators across the world took extraordinary measures to promote financial stability – often at the expense of rules that deter moral hazard and risk-taking behaviour by bankers.
Max headroom: capital buffer relief
The ECB, the Federal Reserve and other prudential supervisors** have relaxed their capital buffer requirements. The Basel Committee chimed in last Friday. The prudential supervisors could do so thanks to the previous crisis, which led to global capital standards that significantly boosted capital and liquidity ratios.
An important reason to relax capital requirements is to create headroom so that banks can keep operating, even though their capital ratios are bound to go down, and may end up below current requirements. The headroom is also important because it calms markets, even if capital levels are high, as my research shows.
Use that headroom
Banks should use buffer relief to absorb losses. The Nederlandsche Bank is a case in point: its capital relief measures are apt: “The strong starting position of the Dutch banking sector allows DNB to temporarily give banks additional leeway to continue business lending and absorb potential losses. In view of current developments, DNB considers … has decided to take the following measures:
- The systemic buffers will be lowered, from its current 3% of global risk-weighted exposures to 2.5% for ING, 2% for Rabobank and 1.5% for ABN Amro.
- The introduction of a floor for mortgage loan risk-weighting will be postponed.
Communicate headroom clearly
Note also the clarity of the communication of the Dutch supervisor. It highlights the strong position of Dutch banks, thanks to efforts since 2009. It then instructs banks to use the buffers and use them wisely.
The ECB also communicates its capital relief actions clearly: “Banks can fully use capital and liquidity buffers, including Pillar 2 Guidance; Banks will benefit from relief in the composition of capital for Pillar 2 Requirements; ECB to consider operational flexibility in the implementation of bank-specific supervisory measures.”
In addition, the Netherlandsche Bank and the ECB quantify the effects of the capital relief measures. For Holland, this is €8bn additional capital headroom, resulting in €200bn extra lending. The ECB estimates that their measures provide banks with an aggregate relief of roughly €120 billion of CET1 capital, enabling banks to potentially finance up to €1.8 trillion of loans to households.
Don’t use the headroom to distribute earnings
The Dutch prudential supervisor also tells banks not to use any headroom for the distribution of earnings: “it is paramount that banks use this freed-up capital to support lending, and not to pay dividend or share repurchases.”
Accounting to the rescue
The Bank of England and the ECB also addressed the accounting standards, specifically IFRS9. This accounting standard is highly pro-cyclical: it is forward-looking and recognises losses in advance, which will exacerbate a downturn.
Given that prudential regulators cannot change accounting standards, they called on banks to be careful when applying forward-looking provisioning. The Bank of England puts it like this: “the PRA expects firms to reflect the temporary nature of the shock, and fully take into account the significant economic support measures already announced by global fiscal and monetary authorities” the ECB uses similar language.
Speed trumps perfection
In all, it is encouraging to see leading bank supervisors take action. They could do so because they learned from the last crisis, established networks, built institutional memory, and because of the plethora of regulatory initiatives that followed after the onset of the Global Financial Crisis. Banks have become much more resilient. Bank supervisors that lack resources, institutional memory, and expertise, should take a look at the initiatives of the supervisors that I mention in this post: the BOE, the ECB, DNB, others. This to prevent paralysis by analysis: “If you need to be right before you move, you’ll never win. Perfection is the enemy of the good when it comes to emergency management. Speed trumps perfection. The problem right now is everyone is afraid of making a mistake“.
"If you need to be right before you move, you’ll never win. Perfection is the enemy of the good when it comes to emergency management. Speed trumps perfection. The problem right now is everyone is afraid of making a mistake." pic.twitter.com/BjZVxCt8Lh— Scott Galloway (@profgalloway) March 16, 2020
… is the title of a book by professors Charles Calomiris and Stephen Haber. The book highlights New Zealand as one of the few countries that never experienced a systemic financial crisis. The institutions in New Zealand are such that they harbour resilient banks.
It is hard to challenge the substance of the book. Following the research of the Basel Committee, for example, today’s New Zealand aggregate Tier 1 capital ratio of 13.50% is well above the sweet spot of around 12%. My own research confirms this as well: 12% Tier 1 is the magic number. This WEF Global Competitiveness Report ranks our banks as number 9 in the world on Soundness of banks with a score of 6.1 out of 7.
**The responses of some supervisors
- Bank of England
- Basel Committee of Banking Supervision
- De Nederlandsche Bank
- European Central Bank
- Federal Reserve