Charles Goodhart says in the FT today that there’s loads of money sloshing
around the banking system; what’s missing is not liquidity, but capital. He
explains:
Just as the central bank is lender of last resort to banks, so banks are
lenders of last resort to capital markets, especially to their own clients
in such markets. When those markets seize up, whether private equity deals
or asset-backed commercial paper (ABCP), contingent claims on banks become
transformed into huge loan obligations. Such sudden extensions of credit can
cause banks to reach prudent lending limits quickly.
This is the process dubbed
"re-intermediation" by Nigel Myer of Dresdner Kleinwort, and it’s
not necessarily a bad thing in the long term. Regulators, for one, will be happy
that they can go back to worrying about banks – which they know and understand
– rather than a vast and shadowy world of hedge funds and structured products
where huge amounts of money change hands without ever going anywhere near a
bank.
In the short term, however, banks are going to run into capital constraints:
they might not have enough in the way of shareholders’ equity to be able to
lend money to everyone who wants it, no matter how creditworthy they are. Says
Myer:
As banks balance sheets are forced to take on more assets, there is a real
potential for capital stretch. Nothing to breach regulatory ratios, we think,
but enough to be noticeable.
Goodhart adds to this worry the fact that the new Basel II regulatory regime
for banks comes into effect in 2008. Up until now, banks’ capital adequacy has
been judged on the basis of how many loans they have outstanding – which
means that if banks suddenly start bringing a lot of new loans onto their balance
sheets, they might have to start worrying about how much capital they have.
As of next year, however, it’s worse than that, since Basel II capital adequacy
requirements are based not only on the sheer quantity of loans outstanding,
but also on the basis of how risky those loans are.
Worsening risk raises capital adequacy requirements, and lower profits and
higher write-offs reduce the capital base. The Basel II framework for regulating
banks’ risk capital will raise the sensitivity of capital adequacy ratios
to risk. When it is introduced in Europe at the start of 2008, many banks
will find their prior cushions of capital, above the required limit, eroding
fast. That could extend and amplify the crisis.
Several of my colleagues at the financial markets group foresaw the dangerous
pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than
we expected.
In other words, just as banks start lending more to their clients, the amount
of capital they have to allocate per dollar lent out will be rising –
bringing the banks rapidly towards their capital limits.
My take is that this is a problem, but probably not a huge one. The big, liquid
banks are solvent and profitable, which means they should be able to raise capital
in the form of either equity or subordinated debt without too much difficulty.
What’s more, if that funding source dries up my feeling is that global central
banks will have a certain amount of regulatory forbearance in the early days
of Basel II. If banks stay within Basel I standards, and are clearly providing
an important source of liquidity during turbulent times in the capital markets,
then I think Europe’s central banks might downplay the importance of the new
Basel II regime.
(HT: Alea)