Can policymakers grasp the nettle of reducing the dangerous leverage in the banking system, or will markets resolve the problem for them?
A chart in a recent publication by the Bank of England’s director of financial stability, Andrew Haldane, (“Banking on the State”) shows the dramatic expansion in the importance of the UK’s financial sector over recent decades.
UK banking assets as a percentage of GDP
Source: Shepphard, D. K. (1971) and Bank of England
Banking sector assets (banks’ total loans) remained at around 50% of GDP for nearly a century, before taking off around 1970 and growing to the most recent level of about five times the national product – a tenfold increase in 40 years.
Given this massive expansion of their loan books, Haldane continues, one might expect the banks to have increased their levels of capital and/or liquid assets to act as a buffer. In fact, he shows, the opposite occurred: capital ratios have fallen by a factor of five in the UK and the US since the beginning of the twentieth century.
Why this descent into recklessness? Haldane’s analysis makes it absolutely clear that the bankers’ enormous increase in leverage is a rational response to the provision of state-sponsored safety nets. If bankers can pocket the profits while passing on the losses to taxpayers, it makes sense to operate with as much leverage as possible and to use as many risky assets as possible. Another chart of Haldane’s makes it clear that the frequency of banking crises worldwide has increased since deposit insurance schemes became widespread.
Given this, Haldane’s recent suggestion that banks should take advantage of their largely state-sponsored 2009 profits to bolster their balance sheets seems like wishful thinking. “There is a strong case for banks, in the UK and internationally, pocketing this windfall rather than distributing it to either staff or shareholders,” he said.
Haldane doesn’t go the final step and draw the conclusion that the current, vastly expanded state safety net actually creates financial instability. Given his position at the Bank of England, this is hardly surprising and, to be fair, he does recommend policy measures that would work to reduce banking sector risk – leverage limits, larger deductibles on state insurance, moving away from protecting bank bondholders at all costs.
But will this happen? Reducing leverage means cutting lending and raising capital, something that contradicts at least one of the objectives set for the nationalised part of the UK’s banking system.
How long the markets will live with this policy confusion is anyone’s guess, or perhaps the denouement of the plot is at hand.
Since there’s an umbilical link between banks and states, Haldane argues, risk can be transmitted both ways. In the middle ages, he writes, “the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks. Causality has reversed.”
Paraphrasing this, if politicians are unwilling to address the problems of excessive banking sector leverage, then sovereign default risk will continue to rise and we could see the government debt and banking sectors in simultaneous crisis. Perhaps, given what’s been happening in Greece and some of the other southern European economies, we’re already at that stage.