Reform or repression: The political constraints to effective banking reform

Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 24 January 2013 and today’s interview is with Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia Business School. Professor Calomiris discusses his recent work that questions what constitutes meaningful bank reform, why it is so necessary and why it is so unlikely. I began the interview by asking Charles why he is of the opinion that recent international efforts to make banks safer are not meaningful.

Charles Calomiris: I guess the best way to explain it is with some examples from the previous crisis. A reform that would be meaningful would be something that would at least have a chance of preventing what just happened from happening again. So let’s look at the US, for example. When Citibank was intervened in December 2008, it was widely recognised that it was insolvent or close to insolvent, and certainly had all the perception in the marketplace of any reliability as a counterparty. It was perceptions like that, of Citibank and others, that led to the collapse of the interbank market in the liquidity crisis of September 2008. What was Citibank’s regulatory capital position as of that date of its collapse and intervention? The market was believing, according to market capital ratios that you can look at, that Citibank was insolvent. The answer is that Citibank had a regulatory capital ratio of 11.8%. Now, what has the Basel committee in particular done with regard to capital standard regulation? It’s basically slightly increased capital requirements to the extent that we can now be confident that all banks will be just as safe as Citibank was in December 2008. Of course that’s a joke, because Citibank was insolvent, even though it was showing a book capital ratio, for purpose of the Basel regulations, of 11.8%, which was far above the minimum. And still above the new minimum.

So what does this all tell us? It tells us that there was a deeper problem here; it wasn’t just that capital requirement needed to be increased a little. And the deeper problem was that the way risk was being measured and the way capital was being measured were deeply flawed. You can’t have a capital ratio regime in which you’re trying to measure capital relative to risk and you measure neither one of them. So the problem is that risk needs to be measured on a forward-looking basis, and accurately. We’re not measuring it accurately if we ask bankers or ratings agencies, both of whom are conflicted parties, to measure that risk. And that’s, ironically, exactly what we do. I think we’re at that level of ridiculousness in the way we conceive of measuring risk.

What about measuring capital? There again, when the bank has a loss, the market recognises the loss but the accountants don’t have to. And the bankers don’t have to and the regulators and supervisors don’t have to. And it’s the combination of those two things: getting in to the crisis, the underestimation of risk and, once you’re in the middle of the crisis, the underestimation of loss and therefore the underestimation of the need to replace capital that are at the heart of the regulatory failure. So if that’s true it’s obvious that simply tweaking the capital requirements a little bit, by a very small increase, isn’t going to solve the problem. It’s most obvious when you look at the Citibank case.

Then, of course, the liquidity requirements, which were added as a new idea; the other big new idea is to cyclically vary capital requirements. Both of these ideas are good ideas; categorically we should be doing both. But the problem is that as soon as the liquidity requirements, which were already deeply politicised and almost beyond recognition of any economics, as soon as it looked like they might have effect they were immediately watered down and then postponed till 2019. In other words, if the bankers don’t like the regulation, or if the politicians don’t like the regulation, the regulation gets put off until it doesn’t have any binding effect. And that, I think, is almost comical with respect to the recent postponement of the liquidity regulation.

VD: You mentioned politics there briefly, and you suggest in your work that the new era of banking instability reflects a pervasive change in the politics of banking that will be hard to reverse. What are the politics of banking exactly, and how have those politics become so powerful?

CC: I think that there’s a very big misconception about what the key issues are in the politics of banking. Most people look at it as an issue about the political power of big banks. There’s no question that there’s an issue with the political power of large corporations, large banks being a part of that. But that is not at the heart of what has gone wrong all over the world. At the heart of what’s gone wrong is that the political is so myopic that borrowers and depositors cannot suffer, and politically are not willing to suffer, and have the ability to prevent themselves from suffering the normal, cyclical costs that come with recessions from the standpoint of depositor loss, potentially, or the reduction of credit. In other words we’ve got to the point where in societies all over the globe, the notion that a depositor could lose a dollar is completely off the table in almost all countries.

Furthermore, the notion that a credit crunch could happen, as is normal during a recession – when banks lose money as they must during a recession as their loan portfolio loses value, banks that are prudent have to contract credit – that’s not popular, and it’s especially not popular prior to elections. The research has shown that, when you look at country after country since, let’s say, the 1970s, there’s been a widespread and unprecedented adoption of measures to protect banks so that we can prevent contractions of credit supply in the short run, or losses to depositors. This is an unprecedented, completely new political shift. If we go back to the 1940s or the 1950s, or any time prior to that, the protection that was offered to banks was very selective: only a few countries, only a few episodes. What used to be the exception has now become the rule. If you’re going to protect banks, that means you’re protecting them from market discipline. That means that you’re insuring their deposits, you’re having central banks or governments bail them out right and left. And if that’s true then there is no discipline on their risk-taking, because the whole point of protecting them is to remove that discipline. If you’re going to do that, which is a political choice, then you have to substitute some kind of regulatory regime that’s effective. But of course, if the whole point of protecting was to make it possible for them to continue to imprudently extend credit during a recession, or to protect depositors from loss, if you remove any disciplinary withdrawal of deposits from banks that are acting imprudently, then it’s naïve to expect that regulators are now going to step in to the breach and do precisely what the politicians don’t want them to do, which is to cause a credit crunch or to pay out to protect banks.

VD: What does current research tell us about how banks can best increase their lending while at the same time ensuring that they comply with stricter regulatory standards? Some would perceive there to be an inherent contradiction in there.

CC: I think there is an inherent contradiction. Right now, of course, you’re seeing this in the UK. You’re seeing very strong efforts by the government, in coordination with the Bank of England, to encourage banks to lend. I’d say the UK and Switzerland are the two most serious countries about reform, precisely because their financial systems are so large relative to GDP – even myopic politicians can’t afford to keep allowing the system to blow up – so you can see the tensions you describe very much in the UK’s attempts to increase the supply of credit to try to encourage banks to do it, but at the same time making it very clear to banks that there are serious reforms underway and they’re not done yet. How does a bank increase its lending without increasing its risk? Not so easily. I’d say it’s pretty much impossible. If you’re telling a bank that you want to increase its equity capital while you asking it to increase its lending – that is, its equity-capital ratio – that’s very hard, because raising capital is costly. Debt financing is less costly than equity financing – not just because of risk but because of a lot of other things, taxes being one of them but I would say that’s not even the most important one. The most important one is that you have to convince people to supply the equity when you raise it in the market, and they’re very concerned that there may be things about your bank that they don’t know that will lead to unexpected loss. Conveying information to would-be equity purchasers is very costly.

The key problem is that you would think: why can’t we have more lending and higher capital ratios? Just get the banks to lend more and raise even more equity capital than the market. In some physical sense, of course you could have it both ways. But the problem is it’s very costly for banks to do that, and so there really is a choice between wanting to have a more prudent banking system and wanting to have a banking system that’s increasing its lending during a tough time in the economy.

VD: What do you see to be the keys to ensuring more prudential regulatory reform?

CC: Well, of course the most fundamental key is that you have to get the political will to do it, because the first issue is: are you actually going to have supervisors and regulators and politicians that want to solve this problem? I think they recognise that they may not want to. If they do want to solve it then you have to change the incentives of the two parties that are in charge of the current system: the supervisors on one hand and the bankers on the other. We have to have rules that measure risk and measure capital credibly. And that means we have to take the measurement out of the discretionary hands of bankers and supervisors. To do that we have to create much simpler rules, and rules that cannot be gamed. Rules that are so simple and so resilient, so robust to any attempt to game, that we can create real accountability. So people can actually see whether bankers and regulators are complying with the simple rules that they’ve established for bankers with respect to capital ratios and cash ratios and the like. So I think the answer is: simplicity is the key. Removing discretionary judgments by bankers and by supervisors about capital and about what liquidity means, and creating much simpler notions of measuring risk, of measuring capital, of measuring cash. This is completely feasible; it has not been done. And in my view that’s the key problem that needs to be overcome.

VD: So finally, Charles, in a nutshell: are you confident about the potential for meaningful reform?

CC: In some countries. I think I mentioned the UK and Switzerland: two countries where, because they have large financial systems, it’s important to their economies that they maintain global linkages and large global universal banks. They have to solve this problem. That’s a little bit like the stories that we’ve seen in some Latin American and Asian countries, where they pursue deep reforms politically, because they’ve recognised that their long-term growth strategy, and even their short-term ability to continue growing, is dependent upon reform. You could tell that story about Chile, to some extent about Brazil, Mexico, Colombia; there are a lot of good stories to be had. On the other hand are countries like the US, Germany, France and Japan. I don’t really see much political will to fix the problem, and I think that the more likely outcome is that it won’t be fixed. And since those countries dominate the Basel system, I don’t see much hope that the Basel committee is going to be getting on the reform bandwagon any time soon.

VD: Charles Calomiris, thanks very much.