Wednesday, February 4, 2009

Watchdogs must not kick banks when they are down

By John Plender Published: February 4 2009 02:00 Last updated: February 4 2009 02:00 Who could argue with Jean-Claude Trichet, president of the European Central Bank, when he urges the markets to stop putting pressure on banks to hold more capital? Encouraging financial rectitude in the depths of a severe recession is, on the face of it, lunatic behaviour. Yet for investors, the issues are not so simple. Mr Trichet is right that market behaviour towards banks is excessively pro-cyclical. In the upturn, investors punish banks that fail to increase leverage to enhance balance sheet "efficiency". In the downturn, they apply equal and opposite punishment to those that appear thinly capitalised. This prompts banks to hoard capital and restrict the lending that is needed to pull everyone out of the trough. Mr Trichet and his fellow policymakers also clearly feel the markets are not giving them due credit for their wide-ranging efforts to address the crisis. Such feelings, while understandable, overlook the fundamental point that the authorities have been slow to address the markets' biggest concern, which relates to the inability to price complex mortgage derivatives. As Charles Dumas of Lombard Street Research has long argued, heads should have been banged together and banks forced to set up a properly researched valuation basis for two-way trading in collateralised debt obligations. Without such an exercise, there is a continuing distrust of banks' solvency. Equally pious is the suggestion from some experts that banks are now adequately capitalised after repeated fundraising efforts. True, the tier one capital ratios prescribed by the Basel capital regime have been bolstered. Yet Basel's risk-weighted capital approach, one of the biggest inducements to pro-cyclicality, lacks all credibility. John Reed, former chairman and co-chief executive officer of Citigroup, writes in a forthcoming essay for the Centre for the Study of Financial Innovation that "with the advent of securitisation and the adoption of 'risk adjusted capital' regimes, we effectively decapitalised the core financial players". He estimates the capital shortfall at $800bn. It is no surprise, then, that investors look increasingly at the reported equity in bank balance sheets rather than Basel numbers. The picture is not pretty. Figures produced by Huw van Steenis of Morgan Stanley for tangible common equity as a percentage of banks' tangible assets, show that the net equity cushion of a dozen or so of the world's biggest banks is less than 3 per cent, and the European banks are notably weaker than the Americans. In short, a 3 per cent fall in the value of the gross assets of these banks leaves them insolvent, other things being equal. This is deeply worrying because the impact of the financial debacle on the real economy is only beginning to be felt in earnest. This year will see big write-offs on commercial and residential real estate, private equity-owned companies, mortgage backed securities and goodness knows what else. It may be indelicate to say so, but many of these banks are, realistically, bust. While policymakers are admirably reluctant to extend the process of nationalisation, more public ownership is both inevitable and potentially helpful. For state control can facilitate more lending. It also removes the acute conflict of interest between taxpayers and shareholders regarding finding a value at which bad assets can be extracted from bank balance sheets without favouring one group at the expense of the other. In such circumstances it is hard for institutional investors to heed Mr Trichet's call to refrain from exacerbating the global recession. If they have worries about bank capital, their fiduciary obligations prevent them from taking a broader, systemic view. That, in turn, echoes a fundamental problem about banking. No bank, however systemically important, can be persuaded to meet the cost of insuring against its own collapse, which is another way of saying the social cost of a systemic disaster is greater than the private cost to the individual bank. In the end, it is the task of regulators, not investors, to address this externality. The vital point is that the watchdogs, which are as prone to pro-cyclical behaviour as markets, do not kick the banks when they are down. John Plender is an FT columnist and chairman of Quintain

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