British Banks’ Comedy of Terrors

The devil is always in the details. And the greatest devils of our economic age lurk in the details of how officials regard the capital – the equity funding – of our largest banks. Government officials have identified far too closely with the distorted, self-interested worldview of global banking executives. The result is great peril for the rest of us.

In this surreal world, the United Kingdom takes on disproportionate influence, because London is still a top financial center – and because the biggest banks in the United States and Europe have proved very effective at playing off American and British regulators against one another. Opinion leaders around the world look to the British for a clever and nuanced approach to financial-sector policy. Unfortunately, they currently look in vain.

To understand the precise problem, you must dip into the latest details of the Prudential Regulatory Authority’s “capital shortfall exercise” with eight major UK banks. I won’t pretend that the PRA’s work is easy reading for a layperson; but anyone who spends a little time with the documents will first laugh and then cry.

With great fanfare (and generally favorable press coverage), the PRA announced that some banks do not have enough loss-absorbing capital – relative to target levels of equity that are ludicrously low. The Bank of England’s Financial Policy Committee (FPC) said that the target should be 7% of risk-weighted assets under Basel III definitions. And, in the PRA’s presentation, this amounts to a leverage ratio of around 3% for most of these banks (again using Basel III definitions), though a couple of banks will need an additional adjustment to reach that level.

In plain English, a supposedly well-capitalized bank in the UK can have 97 cents of debt per one dollar of assets (and just three cents of equity). Such a low loss-absorption capacity would get you run out of town in the US, where regulators are weighing a 5-6% leverage ratio (twice as much equity on a non-risk-weighted basis), and some responsible officials are still pushing for 10% or higher.

So much for the laughs. The tragedy in the PRA’s exercise is British officials’ apparent belief that they are carrying out real reform, rather than setting the stage for serious trouble. To be fair, some of what the PRA did makes sense – including adjusting risk weights and taking into consideration losses from “future conduct costs” (translation: penalties for breaking the law will be substantial). And the treatment of investments by banks in insurance companies is sensible relative to the alternatives.

But the potential for more tears for taxpayers – still reeling from the cost of rescuing the Royal Bank of Scotland (RBS) – looms large. The invitation to banks to game the risk-weighting system further is stated plainly: “In line with the FPC recommendation, the PRA has accepted restructuring actions which, by reducing risk-weighted assets, will credibly deliver improvements in capital adequacy.” In other words, the banks can change how they calculate risk – for example, by tweaking their own models – in ways that will make them look better as far as regulators are concerned.

The British authorities believe that they are building a resilient global financial center that is capable of assuming big risks and withstanding large shocks – either home-grown or transmitted from abroad (that is, from the eurozone). But even HSBC, the best capitalized of the lot, has a leverage ratio of only 4.6%, while Barclays’ ratio is under 3%. In a deeply unstable world, these are paper-thin cushions against losses.

The margin for macroeconomic, prudential, and operating error is similarly small. The British – and the rest of us – have made many such errors in the last decade. At risk is everyone who has a job in the UK, as well as all financial institutions that have significant operations there – including a huge proportion of all global banks.

The idea that the British set any kind of standard for bank conduct was exploded by last year’s Libor scandal, while the fiasco at RBS destroyed the notion that UK officials know how to handle a failing bank. And now the PRA has confirmed that the British authorities do not even have a firm grip on the basics of regulating capital – that is, determining how much equity is safe for large complex global financial institutions.

British officials – and those elsewhere – should take a day off and read Anat Admati and Martin Hellwig’s book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It, an inspired “how to” guide for thinking about why we need more equity in our financial system. Then they should come back to work and do their job properly, by phasing in much higher capital requirements in a responsible manner.

Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You.