Banks fail to in­spire con­fi­dence of investors

The National - News - Business - - The Markets - Mark White­house

Al­most a decade af­ter a cri­sis that nearly brought down the global fi­nan­cial sys­tem, mar­kets still aren’t show­ing much con­fi­dence in banks. It’s a trou­bling phe­nom­e­non that US and Euro­pean lead­ers ig­nore at their peril.

It’s un­der­stand­able that, af­ter years of wran­gling and thou­sands of pages of new rules, reg­u­la­tors might want to con­sider their mis­sion ac­com­plished. They have changed the way they su­per­vise the sys­tem, re­or­gan­ised de­riv­a­tives mar­kets, sub­jected banks to reg­u­lar stress tests and in­sti­tuted new re­port­ing re­quire­ments. To bol­ster banks’ loss-ab­sorb­ing ca­pac­ity, they have re­quired hun­dreds of bil­lions of dol­lars in added cap­i­tal.

Yet, as former US trea­sury sec­re­tary Larry Sum­mers has taken to point­ing out, mar­kets don’t ap­pear to be­lieve that banks are much health­ier. This is ev­i­dent in how they value eq­uity – that is, the amount by which a bank says its as­sets ex­ceed its li­a­bil­i­ties. Back in the early 2000s, investors of­ten paid US$2 or more for each dol­lar in book eq­uity, a sign that they trusted banks’ ac­count­ing and ex­pected to reap sig­nif­i­cant prof­its. Now, though, even af­ter the mini-boom fol­low­ing Don­ald Trump’s elec­tion, they are valu­ing the largest five US banks at about $1.16 per dol­lar of book eq­uity, and the top five Euro­pean banks are at about 65 cents.

What gives? De­clin­ing prof­itabil­ity is one ex­pla­na­tion. With fore­casts of long-term eco­nomic growth much lower than they were in 2007, investors can’t ex­pect banks to make as much money. Also, new reg­u­la­tions re­quire a lot more em­ploy­ees to gather data, as­sess risks and imagine worst-case sce­nar­ios. Al­though one could ar­gue that banks should al­ways have been do­ing these things, the added cost means there’s less money left over for share­hold­ers.

Smaller re­turns, though, can’t ex­plain the whole gap. Trust mat­ters, too. Af­ter a cri­sis in which sup­pos­edly well-cap­i­talised in­sti­tu­tions sud­denly found them­selves in dis­tress, it stands to rea­son that investors wouldn’t have much faith in the num­bers banks pro­duce – par­tic­u­larly given how opaque the ac­count­ing tends to be. Investors might also have come to recog­nise what Mervyn King, the former head of the Bank of Eng­land, calls “rad­i­cal un­cer­tainty”: it is im­pos­si­ble to fore­see and as­sign prob­a­bil­i­ties to all the things that can go wrong with a bank.

What to do? Sim­pli­fy­ing reg­u­la­tion could help. A lot of the most bur­den­some rules arose be­cause banks have been so re­sis­tant to the el­e­gant ap­proach of sharply in­creas­ing loss-ab­sorb­ing eq­uity. Even with all they’ve raised in re­cent years, the largest banks’ eq­uity amounts to about 6 per cent of to­tal as­sets on av­er­age (mea­sured ac­cord­ing to in­ter­na­tional ac­count­ing stan­dards). If they had closer to 20 per cent, enough to weather an un­fore­see­able dis­as­ter and still be well-cap­i­talised, they would in­spire greater con­fi­dence and re­quire less su­per­vi­sion.

By mak­ing share­hold­ers more fully re­spon­si­ble for losses, the added eq­uity might also cre­ate an in­cen­tive to un­lock value by di­vid­ing the largest, most com­plex banks into more man­age­able and un­der­stand­able pieces.

Eq­uity alone prob­a­bly isn’t enough. Any in­sti­tu­tion that de­pends on short-term bor­row­ing to make long-term in­vest­ments – be it a bank, a hedge fund or a money-mar­ket fund – can be­come the tar­get of a panic, with econ­omy-wide reper­cus­sions.

Only a much more rad­i­cal re­struc­tur­ing of the fi­nan­cial sys­tem can ad­dress this weak­ness. Mr King, for ex­am­ple, has pro­posed a sys­tem in which the central bank would ef­fec­tively guar­an­tee all short-term debt and strin­gently limit the kinds of in­vest­ments that could be fi­nanced with it.

To­gether with higher eq­uity re­quire­ments, such an ap­proach could al­low most other reg­u­la­tions to be scrapped.

Mar­kets are send­ing a warn­ing: the fun­da­men­tal change that the cri­sis called for has not hap­pened. The bat­tle to achieve in­cre­men­tal change has left ev­ery­one fa­tigued with­out fix­ing a flawed sys­tem. It may take an­other big dis­as­ter to drive that les­son home.

Robin Marchant / Getty Images

The former US trea­sury sec­re­tary Larry Sum­mers says mar­kets don’t be­lieve that banks are much health­ier.

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