Sunday, 17 June 2012

Sunday, June 17, 2012 Posted by Jake 3 comments Labels: , , ,
Posted by Jake on Sunday, June 17, 2012 with 3 comments | Labels: , , ,

In June 2012, John Vickers who headed the Independent Commission on Banking was very upset that some of his recommendations were rejected by the Chancellor, George Osborne. Was it just his hurt pride? Or does he spot another rip-off being pulled over our heads while we aren't comprehending?

The most important recommendation rejected by Osborne was:

"All ring-fenced banks with a RWAs-to-UK GDP ratio of 1% or more should have their minimum leverage ratio increased on a sliding scale (to a maximum of 4.06% at a RWAs-to-UK GDP ratio of 3%)."
(RWA - Risk Weighted Assets)

What this means in practice:

Never forget, the Credit Crisis was caused by banks borrowing too much. This leverage ratio refers to the ratio of how much a bank can borrow (and then lend on to its customers, or play with in the banking casino) relative to its Tier1 Core Capital. The higher the permitted leverage multiple the more the bank can borrow.

The banking industry claims that setting the higher requirement would be bad for the economy - higher prices and lower growth. The Bank of England, in a report from April 2011 (see later), says this isn't true. Who should Osborne believe? The City which provides 50% of Tory party funding, or the Bank of England which doesn't?

The Future of Banking Commission, set up after the Credit Crisis hit, reported in 2010 that bank executives have every reason to maximise the money they can borrow as it boosts the return on equity and net revenue. Page 60 of the report (scenario: banks can borrow at 4% and lend at 5%) provides some figures illustrated on this graph:

"The FSA has noted that prior to the financial crisis, many investment banks calculated net revenue and then determined the total size of their employees' bonuses by reference to a compensation ratio (typically between 40% and 50%). As Sir Martin Taylor has noted,
'Paying out 50% of revenues to staff had become the rule, even when [because of accounting rules] the ‘revenues’ did not actually consist of money.'"

The “Tier1 Core Capital” is money held by a bank that nobody has the right to take away.

This includes
-         Retained profits
-         Equity capital.

Retained profits are those profits that are not paid out as bonuses to staff or as dividends to shareholders. Retained profits belong to the bank, held as reserves. 

Equity capital is the money raised by the bank by selling its own shares. A shareholder has no right to demand his money back from the bank itself. All a shareholder can do to get his money is sell his shares to someone else. He can’t force the bank to give him his money back in exchange for the shares.

Osborne accepted the recommendation for 'ring-fencing' banks. We explained what a 'ring-fenced bank' is in more detail in an earlier post. For now we focus on the amount these banks do and how much they can borrow.
Independent Commission on Banks
What a ring-fenced bank is for: Simply put, the bank borrows money from one group of people, and lends it to another group of people.

The people who lend money to the bank (including us: our bank deposits are effectively loans from us to the bank) expect
a)      some kind of interest payment (generally ranging between paltry and piffling).
b)      to be able to get our money back when we want it

The people who borrow money from the banks (including us, in the form of mortgages, credit card loans, business loans, etc.) expect to pay interest (generally ranging between excessive and extortionate). These borrowers are expected
a)      to make their interest payments on time
b)      eventually to pay back the loan

The bank makes its profit by paying interest on the money it borrows at a lower rate than it receives on the money it lends. The profit comes from this margin between the rates.

Shareholders: A bank has shareholders investing their money. This money is used as a buffer in case some of the borrowers can’t pay back their loans. If this happens, the shareholders’ money can be used to pay back the people who lend money to the bank. Shareholders expect
a)      to receive dividend payments for their shares
b)      to see the value of their shares grow as the bank grows
c)      to be able to sell their shares to someone

The profits of a bank are shared between
a)     the shareholders, in the form of dividends
b)     kept by the bank, to boost its buffer of reserves
c)     the bankers, in the form of bonuses

From the nation’s point of view
a)      Shareholders take the risk of losing their money, in return for the hope of earning dividends and capital gains.
b)      The more shareholders funds being held by the bank, the less likely the bank will run out of money and need a rescue.
c)      If a rescue is needed, then the taxpayer is forced to bail out the banks. So the bigger the shareholder buffer the safer we are.
d)      A bail-out was what happened in 2008 and continues to this day. That’s why the economy crashed.

From the bankers point of view
a)      Shareholders are a drain on profits, which should be paid to them in bonuses.
b)      Shareholders' money is easily replaced by cheaper borrowing (e.g. pay our depositors 0.1% interest, or less!), so long as the government lets us get away with it.
c)      Shareholders are unnecessary, because the nation will bail the bank out when required – as is happening now.
d)      Erm.  That’s it.

Bankers claim that increasing the capital ratio will make borrowing more expensive for us Britons and will generally be bad for the British Economy. However, the Bank of England, in a report from April 2011, stated

"We conclude that even proportionally large increases in bank capital are likely to result in a small long-run impact on the borrowing costs faced by bank customers. Even if the amount of bank capital doubles our estimates suggest that the average cost of bank funding will increase by only around 10-40bps [1bps =0.01%].  (A doubling in capital would still mean that banks were financing more than 90% of their assets with debt).  But substantially higher capital requirements could create very large benefits by reducing the probability of systemic banking crises."

Banks pretend that the prosperity of the nation depends on the banks being highly leveraged. The graph below from the Bank of England’s report shows that historically there is no link between how much the banks are leveraged (how much they borrow compared to core capital) and how fast the British economy grows. In spite of massive increases in bank borrowing the trend line for GDP growth has been flat.

From the politician’s point of view – Tory and Labour alike – the priorities are:
a)      Do what is necessary to get elected
b)      To get elected you need funding from friends with spare cash to donate
c)      Make friends, ensure they have plenty of spare cash to donate
d)      Then run the country.
e)      As for the people without money…well, they are all in it together!


  1. Discussion on the amount of leverage whilst illuminative is not going to stop boom and bust - what we need is an end to Fractional Reserve Banking

  2. Ending Factional Reserve Banking is unlikely to have any affect on financial fragility. Banks lend and then sort out their reserves later - either through interbank borrowing or, if this is not adequate, then from the central bank. A central bank that does not ensure that the banking system has enough reserves threatens the payments clearance system and so risks crashing the real economy.

    John Carney gets it:

  3. Thanks to leveraging, there is the equivalent of $700tr global total looking to earn a return. To sustainably make 1% each of the 7bn men, women and children on the planet has to make & hand over an average of $1k per annum.

    It can't happen. The only way any significant return can appear to happen is through asset inflation.

    Next time the asset bubble bursts we will again rue the lax curbs on banks.


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