Policy Exchange

The Chancellor, George Osborne, is set to outline his proposals for banking reform at the Mansion House tonight, with a White Paper to follow. The proposals are likely to follow the Independent Banking Commission (or Vickers) Report with ring fencing of domestic banks and higher capital ratios the cornerstone of the proposals. Indeed, the Chancellor has been campaigning in Brussels to be allowed to go beyond the Basle III recommendations and gold plate the UK banks, with the even higher capital requirements recommended in the report.

The idea behind the Vickers report is a sound one in theory – that never again should the UK government have to bail out the banks as it had to with RBS and Lloyds/HBOS. So it’s proposing to ringfence the retail banks, keep the “casino like” investment banks separately capitalised and increase capital requirement generally for large UK banks. The report recommends a minimum tier one equity capital ratio of 10%, above the level required in Basle III for even systemically important banks, which means UK banks will have some of the highest capital ratios in the developed world.

The analysis that the banks should have more capital is a sound one. The more capital they have the more losses they can absorb before they get into trouble, so it is understandable that politicians and regulators want them to have high ratios. However, they also want the banks to lend more money to companies and individuals. If capital markets are open and shareholders are willing to give the banks more equity then you can have rising capital ratios and more lending. The problem today is that we are far from this ideal state of affairs. Capital markets, particularly for equity, are pretty much closed to banks, which is why the Spanish government is just about to borrow €100bn to recapitalise its banks. If the markets are closed there are only two ways they can increase their capital ratios, retain earnings or shrink their balance sheets, or some combination thereof.

That combination is exactly what UK, and other European banks are doing, and capital ratios are rising. Good news you would have thought. But, and it is a big but, it is being done at a cost. That cost is stagnating or declining bank lending, which stems from the part of the rising capital ratio which comes from shrinking balance sheets. The Bank for International Settlements in their June report noted that cross border lending in Euro Area banks declined by $466bn, which it attributed to de-leveraging. In the UK too bank lending has been struggling. In the Bank of England’s own analysis of bank lending it showed lending to corporates dropped by some £9bn in the three months to February alone, while M4 lending - the broadest measure of lending - was some 4.7% lower than a year ago in April.

As long as the Government persists with this insistence of banks raising capital they will not be able to increase lending. Project Merlin is simply a waste of time in these circumstances. The banks will do their best to get close to their targets to get the politicians off their backs but there is a limit to what they can do because of the capital rules. So the banks offer loans only if they are capital efficient. Unsecured lending to corporates, particularly to SMEs, is simply too capital intensive. The banks offer loans but only if they have security, such as a house or a personal guarantee against the loan. Often companies either cannot or do not want to offer such security. So we end up with banks saying there is no demand and companies that there is no supply. The situation is similar with lending to individuals. Mortgages with a 40% deposit are capital efficient, ones with a 5% deposit are not. So in theory the supply is there but not many individuals can meet the requirements. The problem is not so much with the banks themselves but their regulators, and that means the Government and Bank of England, who set the capital requirements.

Sadly the Governor of the Bank of England, Sir Mervyn King, does not seem to understand this problem either, since he keeps urging the banks to build more capital. All well and good Sir Mervyn but if the banks cannot lend your quantitative easing programme will not work either. You can print all the money you like but if it does not generate credit growth it is not going to have any effect on the economy. That is why despite the quantitative easing M4 money supply is still shrinking.

If Mr Osborne truly wants to get the economy moving he has to try and stop gold plating the banks now. In an ideal world he should put his White Paper on bank reform on the backburner until the economy is properly recovering. If he is not prepared to do that he should at the very least build in some flex for banks to undershoot their capital targets for the time being. Theoretically the Bank of England will have the ability to do this under their new supervision powers but it shows no desire to use the flexibility it has been given. Leaving this to Sir Mervyn is too big a gamble since he has consistently failed since the start of the crisis to understand that the banking system is the crucial conduit for monetary policy.

In a recent interview the Chancellor said that the error politicians often made was to try and stick to a policy when it was evident it was wrong. They needed to stop digging, put down the shovel and get out of the hole. Mr Osborne should stop digging on gold plating the banks. It is said that he will not implement the Vickers recommendations on leverage, sticking to a capital allocation of 3% of total assets under Basle III rather than the 4% recommended by Vickers. That is a start; now he should go the rest of the way. It would give the banks, and hopefully the economy, some breathing space now before it is too late.