Best Rule for Safe Banking Gets the Snub
A few weeks ago, a Parliamentary commission issued a surprisingly radical report on how to reform the U.K. banking system. This week, Chancellor of the Exchequer George Osborne released the government’s point-by-point response. He says he will add some of the commission’s proposals to legislation already moving through Parliament; regulators can apply others without the need for new law. That’s all fine, but it’s a pity these don’t include a higher leverage ratio -- the report’s most valuable idea.
Adopting a leverage ratio wasn’t the proposal that attracted the most attention. The commission instead won headlines by calling for the creation of a new criminal offense of reckless mismanagement of a bank. The feeling that somebody should be in jail for what has happened since 2007 is at least as strong in the U.K. as elsewhere, so the idea is popular. It is good policy, too, despite some practical difficulties, and Osborne deserves credit for saying he will deliver.
Some of the conduct detailed in the report was reckless enough that it might meet a reasonable criminal standard -- and the harm was vastly greater than ordinary crimes cause. For its deterrent value, and to answer the public’s call for justice, the worst and most senior offenders in a financial meltdown should be at risk of going to jail. As long as the prospect of criminal prosecution doesn’t block the flow of information and militate against effective regulation and adequate civil remedies -- risks the report acknowledged and that the government must guard against -- we are for it.
The same goes for another headline-grabber: the proposal to defer bankers’ performance-based pay for as long as 10 years. The commission also said regulators should be able to claw back bonuses if a bank gets into financial trouble, or void them if it has to be bailed out. This pushes incentives in the right direction, by leaning against the short-term pursuit of excessively risky transactions to goose profits, ultimately at taxpayers’ expense. Again, give Osborne credit for promising to put this into effect (and give him some more if he actually keeps the promise).
However, as we have frequently argued, the most fundamental guarantor of a bank’s financial viability is its capital. The commission went over the arguments for requiring banks to finance more of their lending with equity rather than debt, and rightly concluded this was crucial.
In particular, it stressed the value of a more demanding leverage ratio, a straightforward benchmark that measures equity as a percentage of all assets, unadjusted for risk. The Basel III accord calls for a wafer-thin minimum of 3 percent. The commission said this ratio should be “substantially higher.” It also said that this is a “complex and technical decision best made by the regulator and it should certainly not be made by politicians.”
Well, the leverage ratio isn’t all that complex. The main reason to make it the measure of capital adequacy is that it is simple, hence more difficult to game than the risk-weighted ratios that regulators have relied on in the past and expect to keep relying on. But the commission is right that politicians should leave it to regulators to decide what is an acceptable ratio. In our view, anything less than 10 percent is dangerous and the case for an even higher ratio is strong.
Osborne’s reluctance to follow this approach isn’t that surprising. He had already made his views known. It’s still disappointing, though. The commission’s reasoning on leverage is persuasive and the chancellor hasn’t even bothered to refute it. This part of the Treasury’s response is conspicuously weak.
The measures he is adopting will make the U.K. financial system safer, yet a more demanding leverage ratio would be worth all the other regulatory innovations put together.
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