Why we’re the world’s most fragile economy

Nick Hubble

A spat about bank capital hit the news late last week. Not only is the topic immensely boring, but it’s also completely misguided.

That should make you stop reading, unless you’re aware of the implications. If banking were to blow up again, so would Britain’s entire economy. The trouble is, just about any problem anywhere in the world could be enough to make that happen if bank capital is too low.

Last week I kept harping on about how the UK is by far the world’s largest international lender. At least as an intermediary. This means our national fortunes are closely tied to the world of debt.

Bank capital tells you how much banks have in reserve. How much of a loss could they take before they go bust? Thanks to the banking industry’s size, it’s basically a measure of how much pain the UK banking system could take before it drags the rest of the country down with it.

So if our banks are undercapitalised, it’s actually a topic of national concern. And international. The fact that it seems boring at first is by design. If it weren’t boring most of the time, we’d be in constant strife. The stakes are so vast that any excitement is dangerous.

The point being that you need to pay attention to the debate about bank capital. Even if it did miss the point, that in itself is revealing. And concerning.

Clueless about capital

The chairman of the Independent Commission on Banking, which drew up the rules on ringfencing retail banking from wildcat banking, recently complained about the lack of bank capital in the UK.

According to the Bank of England (BoE), the amount of capital is up ten-fold since 2008. Chairman John Vickers and his economists say otherwise. It’s more like two to three times.

The fact that the BoE and a lead authority can’t even agree on the amount of capital banks hold only highlights how clueless their misinformed opinions about regulation must be. If you can’t agree on the facts, how can you possibly regulate the industry?

Not that the banks themselves are any better. Thanks to some iffy accounting rules, banks can measure their capital in creative ways. By the time they’re done, they don’t know what’s going on either. That’s part of what went wrong in 2008.

To a bank operating in a free market, capital is its lifeline and buffer against failure. It must be cherished and managed carefully.

To a bank operating in a regulated economy, capital is a requirement that holds you back. If you want to outcompete, you find ways to fudge your compliance with that requirement. Those best at manipulating their way around capital regulation do best. If something goes wrong, just get a bailout from the BoE. After all, you complied with their capital rules…

The result is a system with bizarre incentives. Most of all, it underestimates risk by design. Everyone is looking for ways to increase risk without breaching the capital rules. So the risks they take aren’t picked up by the measures the regulators watch.

Unfortunately, the same system is at the foundation of our national economy and tax base.

A British bank is run on obfuscation

The problem with discussing bank balance sheets is that the topic is completely obscure. The various editors at Southbank Investment Research can’t even agree on how banking actually works.

And the regulation of bank capital only makes things even more obscure. The solution, since the financial crisis, was of course to obscure things further. That way it looks like the politicians have done something. And without anyone able to understand it, they can claim it’ll lead to utopia all they like.

Banking is obscure by nature, so none of this is any surprise. A storage company can’t go and lend out your garden furniture to a hotel in Morocco because you won’t be needing it for the winter. And yet a bank can lend your deposited money to hotel in Morocco just fine. Without obscuring the matter, banking would be exposed as a fraud. That’s why it needs dedicated laws to legalise it.

The problem here is that people rely on regulators to see through the mist. They assume the BoE will reign in the banks. But that’s just silly. Every industry in the world controls its regulators. They just use the power in different ways.

Some implement high levels of costly regulation to prevent new competition from entering the market. Others implement lax regulation to allow excessive risk-taking behaviour.

Try starting a bank and you’ll see who benefits from the rules. But our focus today is on the second matter – risk taking under the cover of regulation.

If regulators existed to cover up excessive risk taking by banks, then the system they’d come up with is the one we have now. It allows the banks to complain about tight regulation, while doing whatever they want in terms of risk-taking behaviour.

Weighing the risks

Part of the capital story is about so-called risk weightings. Under these rules, if a bank uses its money in risky ventures, it has to hold more money in reserve as a buffer for losses. Safer ventures allow a bank to keep less capital in reserve.

The confusion about how to weigh risks is what allows some to claim banks are under-capitalised, while others say bank capital has increased ten-fold. It depends on the arbitrary weightings of risk you use.

The stupidity behind the system of risk weighting is obvious. Banks end up being very risky, because they all push to the limits of their regulatory restrictions.

Banks specialising in low-risk investments and lending keep less capital in reserve. Banks specialising in high risk keep high reserves, but they’re still invested in risky assets. Either way, risk is high. And it doesn’t vary from bank to bank, because all push the envelope to the point they can under regulations.

The deeper problem is in trying to figure out what’s risky and what’s not. Nobody learned from 2008 that risk assessments can change fast and be outright wrong. Especially if you’re relying on dodgy data to compute that risk. Such as “liar loan” documents.

Politics enters the fray too. Is sovereign debt low or high risk? The obvious answer is that it depends on the country. But that’s a politically incorrect answer. It’s practically racist, nationalist and so on.

It’s also a confusing answer because most countries in the world can print money. So a default is practically the honest thing to do.

In the eurozone, the Greeks and Italians can’t just print money like they used to in order to escape their debts. This was supposed to make them more responsible – a funny idea in hindsight. Instead, it gave them access to lower interest rates. And so they borrowed even more.

But if they can’t print their way out of their debts like other countries can, surely this makes their debt incredibly risky? And thanks to risk weighting rules, banks haven’t got to acknowledge this risk, which means that problem is hidden on bank balance sheets around the world, just waiting to blow.

Another example of politics meddling with bank balance sheets featured in the 2008 crisis. Is lending to the poor low or high risk under capital rules?

Change the rules and definitions on this and you can create a lending boom among those who can’t afford to repay. But even when they can’t repay, they can still vote. Do you see the conflict of interest?

The last person you want to make capital rules is a politician. But that’s where they come from. And that’s who can change them.

No wonder we can’t even agree on the facts.

Implosions are built into the system

The problem with running a fraudulent business model, whether it’s legalised by legislation or not, is that it eventually collapses. People withdraw the money that the bank relied upon.

This usually happens when the investments and loans that banks make go sour. And so the link between Britain’s economic wellbeing and the world of debt becomes clear. Any major economic crisis in the world leads to London’s financial markets.

Right now, a particularly bad one is drawing near. By my calculations, it’s the worst ever. No amount of capital would protect us.

Given your ties to the UK, you need to be aware of threats like these. Because when something like this does eventually go wrong, it’ll show up on your brokerage account balance within minutes.

Act now, before contagion takes hold.

Until next time,

Nick Hubble
Capital & Conflict

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