Of course we can raise the buffers, but at what price?
As a major player in the financial sector, ING aims to contribute to debate on the future. In this context, the FD published today this contribution of ING Bank's vice president Koos Timmermans
The remedy of compulsory extra capital reinforcement is probably worse than the disease
By Koos Timmermans
Het Financieele Dagblad, 13 December 2013
According to Arnoud Boot and Sweder van Wijnbergen, Dutch banks are suffering from a serious affliction: apparently, they don’t have enough capital to support the economy. They add in passing that bankers lack knowledge (FD 6 December). With my 27 years’ experience in the sector, I could not let this go unchallenged. Not least because both economists interpret an aim that I support: a safe banking sector that facilitates lending.
Boot and van Wijnbergen reinforce their point by making a comparison between banks and “ordinary” businesses. This comparison is often made, but it is nonsensical: banks are not “ordinary” businesses. One of their key roles is to pass on the savings of consumers, businesses and other parties to parties who need that money to buy a house or to invest. This involves transforming risks, scope and term.
For the bank, deposit-taking is loan capital that stays on the balance sheet for a relatively long time. Consequently, there is relatively more loan capital on a bank balance sheet than on the balance sheet of an “ordinary” business. Comparing the debt/equity ratio of ordinary businesses with the debt/equity ratio of banks is like comparing the average water consumption of ordinary businesses with the average amount of water consumed by swimming pools.
Comparison between banks and
“ordinary” business is often made,
but it is nonsensical
Boot and Van Wijnbergen also criticise the system of risk weighting in the balance sheet management of banks. The amount of capital (or equity plus risk-bearing loan capital) that a bank keeps for lending or investment does indeed depend on who the other party is and the extent to which the loan is secured. It goes without saying that the risks associated with Dutch government securities or a mortgage are different from the risks associated with lending to an internet start-up.
Of course, it’s important to look critically at whether or not the risk weighting applied is adequate. However, branding the entire system as complex or manipulatable is too facile.
The methodology has after all been set out in the international Basel III rules because these rules essentially serve a useful purpose: they give banks with few high-risk assets on their balance sheet extra financial clout to fulfil their supporting role.
The comparison with the capital position of American banks also falls short. A recent ECB report showed that since 2008, the capital positions of European banks have been substantially reinforced. Although the ECB also identifies differences with the US in the level of capital buffers, it points out that these are mostly to do with different accounting rules. Adjusted for this, the buffers of American institutions are not much higher than those in Europe.
What is more, in America, most mortgage lending is by semi-public institutions; if this were taken into account, the buffers in America would probably be lower. Finally, the ECB assesses the lending portfolios of American banks as being significantly higher risk. To explain this, it says, and this is worth noting, that the European system of risk weighting is far less advanced in the US. Whatever the case, what the figures suggest is that there is not currently a need for further capital reinforcement in Europe.
This does not of course alter the fact that buffers can always be higher. However, the question is: who is going to pay for raising all that additional capital? After all, raising capital is considerably more expensive than issuing debt instruments or deposit-taking.
It is argued that shareholders would be willing to accept a lower return. This is based on the idea that banks that have access to more capital would be better able to spread the risks of lenders. This is not a convincing argument. Not only does this supposition assume an awful lot of trust in the efficient operation of markets, furthermore, experience has shown that risk perceptions cannot be explained one-to-one by the capital structures of banks.
This link is more complex: the quality of the assets, the earning capacity, the business make-up and the macro-economic environment also play a role. Banks with the highest capital ratios are not necessarily the most resilient and do not necessarily have the lowest borrowing costs.
Added to this, the banking cost structures are already under pressure from the new bail-in rules. If a business fails, some debt instruments will from now on be treated as equity. Although passing on the risks to the taxpayer has been ruled out, and with good reason, this means that lenders will be much less willing to put their money in banks – or only at a higher price. This would drive up the cost of debt financing, which would put pressure on lending.
Shareholders, too, would see the safety net of the government disappear – and run more risk as a result, which in turn would actually put pressure on the readiness of investors to invest their money in bank shares.
In brief, there is no obvious need for banks to increase their capital any further, whether compulsory or not, whereas the question is whether investors are willing to put up the capital required. This type of measure could contribute to greater security, but it remains unclear who will foot the bill. A bank has few other options than to pass on the price of capital, as set by the market, to its customers. In the meantime, society is asking, and with good reason, not just for stable, but also service-oriented banks. Any further reforms must therefore be critically assessed for their impact, not just on the sector, but also on the real economy. And then we’ll see: the remedy of compulsory extra capital reinforcement is probably worse than the disease.
Koos Timmermans is vice-chairman of ING Bank