Banking reform has been made more confusing than it needs to be

Economic View

We need to take the debate about banking back to the basics (Getty Images)

“All that is necessary for the triumph of evil is that good men do nothing.” There’s some uncertainty over whether Edmund Burke actually made this observation. But, regardless of its provenance, the wisdom merits a tweak for our times. Today the necessary condition for vested interests to prevail over the public interest is that good men don’t understand what the hell is going on.

Something has happened in the UK banking reform debate. Sir John Vickers, a central figure in the Government’s post-crisis financial overhaul, has questioned whether the Bank of England’s latest proposals to shore up the sector go far enough.

Yet this debate is perfectly impenetrable to the non-expert. Read the exchanges between Sir John and the Bank (here and here) and you will soon slip into a numbing bath of acronyms and jargon from which you will very likely not resurface any the wiser.

G-SIBs, D-SIBs, SRBs, RWAs, Tier 1, Basel III, CoCos … These names will float across your vision, like the members of the world’s most boring rap group. You will read about the appropriate threshold for the activation of “a risk-weighted SRB rate of 3 per cent” and the relevance of “counter-cyclical buffers” and, you will, quite understandably, conclude there is something better you could be doing with your time.

But ignore the detail. This complexity is the outcome of years, perhaps even decades, of horse trading between bank lobbyists, regulators and politicians from all around the world. As a non-expert you’re not supposed to be able to follow it. It hasn’t been designed to confuse ordinary people. That’s just a happy side-effect (as far as the banks are concerned).

So clear it from your mind. Focus, instead, on the essentials. Banks are not as complex as they are made out to be by bankers and regulators. A bank has a balance sheet just like any other business. On the asset side of the balance sheet are its loans to customers. On the liabilities side are the current account deposits of customers, plus borrowings from the wholesale capital markets and, most importantly of all, the equity of its investors. The liabilities of a bank fund its assets.

Equity is what gets eaten into first when a bank makes losses. If the equity is all used up, the bank is bust. And as we saw in 2008, that can mean taxpayers forced to step in to stop these institutions collapsing and taking the entire economy down with them. That’s why regulators must make sure banks have a sufficiently large tranche of equity financing on their balance sheets.

The Independent Banking Commission, which Sir John chaired, said in 2011 that UK banks should be forced to fund themselves with a certain amount of equity in order to make sure they would not need to call on taxpayers again. It recommended more equity than these institutions typically had going into the financial crisis.

But the Bank of England seems to be planning to let banks fund themselves with less equity than Sir John recommended. So he has raised his voice in protest. The Bank of England does not agree that it is softening its requirements. In a reply to Sir John, two deputy governors, Sir Jon Cunliffe and Andrew Bailey, have claimed the Bank is respecting the original plan and, in fact, going further.

Part of the debate seems to hinge on whether one should count a type of special bank debt that automatically converts to equity in a crisis as a part of a bank’s official equity or not. There’s a strong case for not doing this, since these financial instruments are clearly untested.

But even this is really a distraction. The differences between the Bank of England and the commission’s proposals are not, in truth, immense. This is more an issue of principle. Sir John believes he and his commission erred on the conservative side in those 2011 equity demands, on the grounds that to push for more might have been economically disruptive. And he sees no good reason why they should be rolled back even an inch by the Bank.

In support of his case Sir John has chosen to cite the analysis of the respected independent expert in finance, Anat Admati of Stanford University. This is interesting. Ms Admati has recommended that a private bank’s equity cushion should be equivalent to between 20 to 30 per cent of its assets.

So what would you guess is the current level of equity for banks being targeted by the Bank of England? Fifteen per cent? Ten per cent? Try 3 per cent. Or 4 per cent at most. And even Sir John’s report, despite his complaints today, only wanted banks to have equity worth a maximum of around 4 per cent of assets. Consider what this means: it implies that a mere 3 or 4 per cent fall in the value of a bank’s assets would bankrupt it – and government ministers and regulators would, once again, need to consider whether to step in. To state what should be obvious: that’s not very much. And that simple ratio – known as the “leverage ratio” – should be focus of debate.

Instead, the discussion gets side-tracked. The commercial banks complain that Sir John is pushing for something that will crush the global competitiveness of the City of London — when the reality is low equity buffers juice up their profits. The Bank of England, meanwhile, claims much has changed in the regulatory sphere since Sir John delivered his 2011 report. And we get showered in those acronyms.

But the central fact is that even Sir John’s slightly tougher equity proposals are insufficient truly to safeguard the interests of the taxpayer. This battle is over small movements around an equity benchmark that has been set far too low. This row doesn’t signify nothing, but it certainly doesn’t signify enough.

British banks have an aggregate balance sheet several times the size of the entire economy. As 2008 showed, failures by large banks represent the pre-eminent economic threat to all our livelihoods. If people grasped what was at stake and how little had been done on equity, the clamour for action would be deafening. But the ordinary citizen, whose money is on the line, is blinded by jargon. And the vested interests prevail.