Uncharted Territory

October 17, 2008

Countercyclical Conundrums

Filed under: Credit crisis, Economics, Rights issues — Tim Joslin @ 10:17 am

Several agendas – or should that be “agendae”?; I told you there was a brave attempt to teach me Latin at school: in fact, I now recollect, so dedicated was my teacher, that, after watching me for a good 5 minutes, he once stopped me swapping stamps in the middle of a lesson! – anyway, let’s get on with it: several agendas were at play in shaping the UK Government’s bank recapitalisation plan.  I hesitate to call it a “bailout”, as it’s not really clear who is being bailed out by whom.  It rather seems to me that the banks, by agreeing to Brown’s plan, are bailing out the economy and the PM.

One influence that seems to have come to the fore during the week between the announcement of a £25bn capital injection (with another £25bn to follow if needed) is the idea of taking measures to encourage countercyclical availability of credit.  That is, it is argued, steps should be taken to discourage bank lending during an upturn and to encourage it during a downturn.  The point is that during the downturn banks have less money for new lending because of the bad debts they have to write off.  The idea I hope I’ve encapsulated – a sort of privatised Keynesianism – is that of the latest economic guru of those who hope to defeat the business cycle, Hyman Minsky.  Even as I write the BBC Sunday evening schedule is undoubtedly being cleared for a documentary on the guy.

The amount of lending a bank can undertake is determined in large part by the amount of surplus capital on its books.  The capital can be thought of as a cushion against loans failing to perform.  The amount that a bank can loan out at any given point in time in the form of mortgages, business loans and so on, against deposits or short-term borrowings, is many times its liquid capital.  It all gets rather technical, but a bank’s capital adequacy can be measured in one or more of a number of ratios under guidelines set by the Bank for International Settlements (BIS) which is based in Basel, Switzerland.  This is why banks report their compliance with the “Basel I” or new “Basel II” sets of rules. The “Tier 1” capital ratio is the one banks most often refer to.  For example in the announcement about its fund-raising as part of Brown’s plan to save the world, RBS notes:

“The capital raising will increase RBS’s pro forma core tier 1 and tier 1 capital ratios by approximately 3 percentage points and 4 percentage points respectively, on a proportionally consolidated basis”.

One way to implement a countercyclic credit policy is therefore to stipulate that banks’ capital ratios must increase when you think credit has become too easy (during the boom) and relax the ratios during the downswing in the hope that banks will continue to lend.  The mechanism is analagous to the setting of interest rates by the Bank of England (and other central banks) but aimed at controlling credit rather than inflation.  I’m fairly sure at least China and India already implement such a policy already since I’ve seen announcements in the FT of adjustments.

It appears that the UK decided last weekend to introduce a countercyclical policy.  All very ad hoc.  And, since the banks were not ordered to increase their capital ratios during the boom years (which might have been a good idea), it’s all somewhat late in the day.  You could say that during one frantic weekend the UK took the decision to embark on an ad hoc, post hoc countercyclic credit management policy!

This policy shift is one reason why – despite having plenty of capital relative to existing regulatory requirements – the UK banks are having to raise £37bn (or more – I think this figure is just the government’s maximum commitment and doesn’t include fund-raisings by Barclays, HSBC, the Santander-owned mortgage banks and Nationwide).  The idea, it seems, is to get them to where they should have been at the end of the boom, i.e. with Tier 1 capital ratios of 9% or more.  The point is that they should then be able to continue lending without the worry that bad debts will send their ratios back down to the level (say less than 6%) where the market starts to lose confidence in them.

A real giveaway that the government is trying to do more than just free up the interbank money markets is the stipulation as part of the bailout that banks must “maintain the availability” of “competitively priced lending… at a level at least equivalent to that of 2007…” (this quote is from Lloyds TSB’s announcement).  The FT may have described the move as a “demented diktat” (curiously this phrasing was noted by various secondary sources on the web, and then apparently removed from the original article), and it may be impossible to enforce, but the banks will have got the point, even if most commentators are baffled.  The danger now is indeed that we go from one extreme to another.  I think Minsky is probably right about that, and – though other aspects of the bailout are demented – the government is right to be doing everything it can to prevent the economy going into a tailspin.  Might have been a good idea to have stopped it flying too close to the Sun in the first place.  I guess there’re a lot of votes in rising house prices.

I do have some qualms about the countercyclical prescription, though.  I dislike the way it relies on the omniscience of policy-makers and regulators.  Make no mistake, this crisis was first and foremost a regulatory policy failure.  We need to understand why they’ve failed before we take the medicine of more regulation prescribed by empire-building bureaucrats.  I suspect what we really need is for the FSA to work smarter, not harder.

More specifically my worry is that you never know exactly where you are in the business cycle.  You may start ordering banks to raise their capital ratios, but asset prices continue to rise so you’re compelled to continue raising ratios.  And on the downside you may allow banks to lower their ratios, but they have no way of knowing the extent of the bad debts on their books, so may still not start lending.

I prefer an agenda of:

1. Trying to damp down price fluctuations in those assets that have most effect on the real economy, i.e. we should be more concerned about residential property bubbles than ones in the stockmarket.

2. Assisting banks and other companies in raising private, not public, capital to cover losses.  Essentially I’m saying that (in the case of the present crisis) the banks paid out too much in dividends in the good years.  There was no way to predict it reliably, but now they need that capital on their books.  Fine, the shareholders may have been able to put it to good use in the meantime.  But now they should pay it back.  Hence my interest in getting rights issues to work properly.

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3 Comments »

  1. […] as a buffer for use in the bad years.  There’s been much water under the bridge since I previously expressed some scepticism, but I still feel inclined to say: “Be careful what you wish for”. Counterfactuals are […]

    Pingback by Ice, Fire and the MPC « Uncharted Territory — February 11, 2009 @ 3:57 pm

  2. […] we simply make it more difficult for the banking system to fail, for example by requiring them to build greater buffers in the good times against customer or counterparty defaults and/or a sudden withdrawal of liquidity from the money […]

    Pingback by Counterfactual Conundrums « Uncharted Territory — February 25, 2009 @ 7:48 pm

  3. […] previously pointed out, this will simply allow asset bubbles to inflate even further.  And, as I noted some time ago, the measure will not be as easily applied as most people seem to think: we never know where we are […]

    Pingback by We need rules, not regulation « Uncharted Territory — February 26, 2009 @ 6:22 pm


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