Banks pushed both ways

This is my latest Perspective column for Fund Strategy. It deals with capital adequacy in banks so it is more wonkish than usual. However, it is an important topic for those trying to grapple with contemporary economics.

Being vilified as greedy is far from the most tricky problem facing bankers at present. They are also literally being asked to take two contradictory actions at the same time.

On the one hand, politicians demand that bankers lend more to help finance the recovery. On the other, bankers are told they must lend less to make their institutions safer.

This column has dealt with one side of the story several times. Extending credit in the absence of economic restructuring will at best only provide a short respite to austerity. In the longer term it is only likely to make matters worse.

But the problems associated with tighter bank lending rules are more intricate. For those without detailed knowledge of the arcane ways of banking they can seem forbiddingly complex. As it happens the principles are simple even if the details are not.

For those with little knowledge of banking it is best to start from a simple model. Once this is grasped it is possible to grapple with the convoluted relationship between banking and the real economy.

Imagine a new institution, call it New Bank, which has attracted £100m of deposits from its first customers. Its safest course of action would arguably be to hold on to the £100m and return funds to the depositors when they withdraw cash.

Such a business model would be problematic for several reasons even leaving aside the bank itself making a loss. From a depositor’s perspective the real value of the cash would be eroded by inflation over time. From an economic perspective the cash would also be wasted as it could be used to finance investment for the future.

Banks therefore tend to lend out a large part of their depositors’ cash while keeping only a small proportion in reserve as core capital. For instance, New Bank might hold on to £5m while lending out £95m to borrowers. This system is known as fractional reserve banking.

Although the system has many advantages it also raises problems. If New Bank’s depositors wanted to withdraw more than £5m at one time it is likely to have a liquidity crisis. That is why it is important to maintain capital at a level adequate to ensure the bank can confidently stay in business.

If there is a panic, a run on the bank, the authorities are likely to have to intervene to restore stability. That is what happened with Northern Rock in 2007.

There are also potential problems on the lending side. Although it is expected that a small proportion of bank lending will go bad if the level gets too high the bank will need to take action to restore its capital. For instance, it might sell some of its subsidiaries to raise cash. Many international banks are taking such action at present.

Nowadays the banks’ capital adequacy rules are agreed under the auspices of a little-known but powerful institution: the Bank for International Settlements (BIS). The organisation, based in Basel in Switzerland, is essentially a central bankers’ central bank. Although it was founded in 1930 it was only in the 1980s, with the Basel Capital Accord, that it became preoccupied with capital adequacy.

The Basel Committee on Banking Standards, part of the BIS, works with national authorities to develop capital adequacy standards for banks.

A London-based bank, for instance, would have to meet the Basel standards but it would be supervised under the auspices of the British regulators. The European Commission also plays a role in bank regulation within European Union member states.

Since the 1980s the Basel framework of regulation has become progressively more complex. There is much room for debate about what should constitute bank capital as well as the levels needed.

The Basel 1 framework, first introduced in 1988, specified that the core capital of banks had to account for at least 8% of their risk-weighted assets. A new framework, known as Basel II, introduced in 2004, aimed to produce a sounder regulatory framework and to take a more sophisticated approach to managing banks’ risk.

The current discussion of bank lending is focused on the Basel III framework that is meant to tighten capital adequacy standards further. It involves a range of measures relating to areas such as the quality of a bank’s capital, its levels of risk and its leverage.

Basel III should be fully implemented by 2019 but many banks are hoping to demonstrate their strength by meeting the capital targets by 2015. An interim set of measures, known as Basel 2.5, was implemented in most major world jurisdictions at the end of 2011. However, America is lagging behind as in some respects Basel 2.5 clashes with its own Dodd-Frank act.

Meanwhile, France and Germany have floated the idea of relaxing the Basel III rules in a bid to maintain economic growth. The Financial Times has reported on a joint paper by Wolfgang Schäuble, the German finance minister, and François Baroin, his French counterpart, which calls for the dilution of some key rules.

Although these are technical questions they have an important bearing on economic prospects. If companies find it hard to raise the necessary funds it is likely that economic growth will suffer.

But while having an overly restrictive set of regulations could damage growth it does not follow that a positive framework would be a panacea. In this risk-averse climate many companies are unwilling to invest even when they do have access to funds. Indeed many large firms are sitting on huge piles of cash.

A healthy banking system is vital to the functioning of market economies. It does not follow, though, that the chronic economic weaknesses can be resolved by tinkering with bank regulations.

A good starting point would be for politicians to stop scapegoating bankers and to start focusing on the weaknesses of the real economy.