Viv Davies interviews Viral Acharya for Vox

September 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/7071]

Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 16th of September, 2011, and I'm talking to Professor Viral Acharya of the Stern School of Business about the recent report issued by the UK's Independent Commission on Banking, chaired by Sir John Vickers. We discussed the report's recommendations on capital requirements and the proposal to ring‑fence banks, retail versus investment activities. Acharya is of the opinion that ring‑fencing is no panacea and that the more important question is whether the risk weights are appropriate. We also discussed the likely costs of the proposals, both to banks and to consumers, and what the implications may be for competition in the banking sector.

I began the interview by asking Viral whether he thought the report was a step in the right direction.

Viral Acharya: I would say it's certainly a proposal that is worth thinking about quite seriously. Whether it is a step forward or not depends a little bit on how the capital requirements for banks and resolution authority for banks evolves in the years to come. The way I see it is that countries such as the UK, Sweden, and some others, where the financial sectors are very, very large compared to the size of these countries, are getting increasingly concerned about facing the kind of problems that we faced in 2008.

And to the extent that the further risks of recession and slowdown in global growth have increased given the tentative recovery in the US and the sovereign debt problems in Europe, I think these countries are trying for something more substantial than what the Basel III reforms are offering.

In particular, Sweden has gone for relatively high levels of capital requirements and the UK is attempting a solution that I think has been on the table only in the UK primarily, which is to really try and separate the riskier parts of banking activities from what I would call the core or the plumbing aspects, such as payment and settlement systems, deposits, interbank markets, and bank lending, which are primarily centered in the commercial banking activities.

So I would say in the end they've concluded that maybe the risks that the commercial banking system, which is at the center of the plumbing, faces from these traditionally noncommercial banking activities are serious enough in the current economic climate that we ought to think about some ring‑fencing of this sort.

Viv:  Do you think that ring‑fencing could mean that banks may be encouraged to take greater risks with activities that are inside the fence, so to speak, such as mortgages, corporate loans, and personal loans, etc?

Viral:  Absolutely. This is a risk that any ring‑fencing operation will have to worry about, which is that ring‑fencing in and itself is not a panacea. What it ensures is that if risks hit the noncommercial banking aspects or if some mistakes happen there – maybe the current UBS trading loss as an example – then they don't fundamentally spill over into the commercial banking aspects. However, as you said, if there are risk‑taking incentives within the commercial banking arm, and what we saw happen through the trading aspects was just a reflection of their deeper problem, then of course we really haven't solved the problem. We've just transferred it somewhere else.

Therefore it's very crucial that the resolution authority, which is that we put in place a measure to wind down in an orderly manner a large, complex financial institution and ensure that their capital requirements are somewhat in sync with the kind of systemic risk that even the commercial banks are taking on, is important.

In fact, I think a point in favour of perhaps focusing more on the traditional banking aspects would be that in the end what really brought down banks and complex organizations in the crisis of '07 and '08 wasn't actually really their trading activities. A large part of the risky mortgages and mortgage‑backed securities that they held were actually not necessarily just in their trading activities. They were actually in their traditional banking mortgage books themselves.

Viv:  Maybe, Viral, we could talk in a little more detail about the capital requirements announced in the report. Banks will be required to hold equity capital of at least 10% of risk‑weighted assets in the ring‑fence business, and both parts of the bank will be required to have total loss‑absorbing capital of at least 17% to 20%. This seems to be out of line with internationally agreed measures, such as Basel III, for example.

Viral:  Absolutely. I agree that they are substantially higher than what Basel III has proposed and they are more in line with the levels of capital requirements that I think Switzerland has been talking about. They are also somewhat higher than what has at least tentatively been discussed in the United States, though we are waiting for further clarity on what will be the systemic capital surcharge for systemically important financial institutions in the US under the implementation of the Dodd‑Frank Act. Now I would like to say two things, though, which is this 10% and 17% or 18% of capital requirements as a function of risk‑weighted assets. Fundamentally the question that has not been put on the table is, are our risk weights right? We had very low risk weights on residential mortgage‑backed securities. What that did was to actually increase the lending to the residential mortgages as an asset class.

Endogenously, therefore, that is, as a response to the capital requirement itself, the residential housing became a systemically quite vulnerable asset class. However all through the crisis, and even post‑crisis, we've continued with a relatively attractive risk weight on this asset class, even though the crisis fundamentally told us that what banks were holding as capital against these assets was not adequate from a sovereignty standpoint as far as investors were concerned.

We are facing a very similar problem with respect to the sovereign debt holdings of the peripheral countries in Europe, which are the bonds being held by banks all over the world. They are essentially, as long as they are in banking books, they are not receiving substantial haircuts or being asked to raise substantial capital. Even though there's no clarity that these bonds will necessarily be backstopped by someone, there's a good chance that they may undergo restructuring and take some haircuts.

So therefore, while increasing the level of capital under some circumstances makes sense, I think we fundamentally ought to ask whether the risk weights are right or not, because otherwise we might be raising capital to 20%. But if we are not charging any risk weights on sovereign debt holdings of some of these countries, we are actually not raising capital against the asset holdings. We need to raise them in a fundamental sense.

The second point I would add here, and let me spend a little more time on this question because it is so important, is that often the current level of capital that an institution has is not as important as what its level of capital is going to be if it was hit by a substantial crisis.

I think this answer ties in with my first point about risk weights. Today, most people who are doing this stress scenario would consider as a stress scenario a substantial haircut on the sovereign debt holdings of some of the peripheral countries in Europe. Now if we are charged zero risk weight on some of these assets, it's clear that current high levels of capitalization are not going to be adequate when you face such a substantial stress scenario.

In contrast, designing a capital requirement that is based on your losses in such a stress scenario has the flavour of implicitly charging higher risk weights to those assets which are going to lose under the stress scenario.

So while I'm supportive of the push for higher capital requirements, I would say that regulators, both in Basel, in the UK, in Switzerland, in the US, they fundamentally need to rethink whether static risk weights that don't change when the system's response to an asset class changes, the static risk weights that don't change when market's assessment of the risk of an asset class changes, are really the right way to proceed going forward.

If we just keep raising capital ratios but we don't change the way we think about risk or the cycle, I think we have a problem.

Viv:  What are the implications for competition in the banking sector?

Viral:  I would say there are two kinds of implications to think about. One implication to think about is that countries like Switzerland and the UK, which are feeling the greatest vulnerability from having large financial sectors relative to their own balance sheets, are in some sense perhaps creating a race to the top. Which is that if their banks hold the right levels of capital and up to sufficiently high levels, they could become the safest banks to work with in the international financial system. It could, under some senses of competition, create actually a race to the top, where, say, banks in the other countries where capital requirements are weaker struggle to actually attract the right counterparties in, say, development business, interbank markets, dealer functions in marketing making, etc.

The second aspect of competition that we have to worry about, though, is the one that, say, Bob Diamond of Barclays came up with, which is, "Oh, if you charge us phenomenally high capital requirements, we will do a jurisdictional audit and take out our businesses and go to countries where capital requirements are in fact cheaper."

Now maybe this is part of the intended consequence of actually charging high capital requirements, which is to shrink the size of the financial sector. If the perception is that maybe it has overgrown its efficient size given that perhaps they were not holding much capital and therefore have implicit access to the government subsidies out there.

Viv:  What do you think will be the impact of these proposals in terms of actual and social costs? And who do you think will be most affected? Could the competitiveness of UK businesses be disadvantaged? And what about public consumers?

Viral:  I would say it's not so clear that greater capital necessarily reduces the banking activity. If anything what we are seeing is that not having adequate capital in the midst of a crisis produces very substantial credit crunches. When banks don't have capital, they fear failure. They fear runs, as a result of which they become quite precautionary in their behaviour, hold liquidity away from interbank markets, hold capital away from actually using the capital to make greater loans to households and real sectors. So you could argue that from the standpoint of having softer lending when you face a risk of a recession or a full‑blown financial crisis, more capital is actually a good thing. Now bankers do take lower risks when they can't do them on the back of greater leverage, but this is primarily an issue of good times. If anything, my view is that the risk that I think the John Vickers Commission Report and some of the other regulators are concerned about is of excessive lending in good times rather than actually facing a credit crunch in good times.

So from the standpoint of having a more countercyclical regulation, I think this is a compromise. Of course, you do not want to stagnate the system to a point that the level of capital is so high that essentially banks don't have sufficiently high incentives to actually make the right quality and level of loans in the first place.

Viv:  Do you think that this week's announcement of a loss of £2 billion in rogue trading at UBS justifies the idea of ring‑fencing? Or put differently, will these proposals ensure that the public in the future will not have to pay the price of excessive risk in the banking sector?

Viral:  I would say it will – my feeling is it will certainly get used very strongly to justify ring‑fencing. But I think we should be clear about a critical point, which is that these kinds of trading losses are really not a systemic risk. This is really something about the risk management at individual institutions. And an individual loss of this size, even at a large institution, is not necessarily going to bring down an entire financial sector if the loss is very specific to that particular trading operation. What we really have to worry about in regulation is that you get an overextension of mortgage lending or an overextension of corporate lending, or a systematic buildup of exposure to one counterparty, like long‑term capital management. These are what I would call systemic exposures, because when an asset shock materializes, that is bad mortgages or corporations or one of these large counterparties getting in trouble, it could risk the meltdown of an entire financial sector.

So I'm not too bothered about the current trading loss. Yes, it makes me worried about risk management at certain kinds of institutions, which is whether banks are investing enough in their risk management practices. But my sense is we'll always have these kinds of occasional individual or, I would say, trading‑specific losses happening in some institutions.

I think whether ring‑fencing is the right way to go, or whether designing capital requirements in a way that better reflects the systemic risk contributions of different activities, they'd be creating, they'd be MNE, they'd be commercial banking. I think that's the critical choice.

My sense is that in the United States the current inclination is to use an additional capital surcharge on systemically important financial institutions. That is something that's possible under the Dodd‑Frank version of the Volcker rule, which requires separation of bank investments into hedge funds and private equity to a de minimis level has the spirit of ring‑fencing.

But I think the John Vickers Commission Report goes a little further in the direction of ring‑fencing. And I think that concern is partly driven by what I mentioned at the beginning of the interview, which is maybe the concern is that the UK and the Swiss financial sectors are significantly larger relative to their GDPs than in the case of the United States.

Viv:  Given the current situation in the Eurozone, how do you see the relative importance or urgency of banking reform relative to what we might term sovereign reform?

Viral:  I would say they're both quite important in my view. The good news about doing banking reform in the midst of a crisis, or at least I would say not exactly in the eye of the storm but maybe just after the storm has subsided, is that this is the time when regulators have substantial bargaining power over the banking industry. Some people would argue that perhaps in the United States the bargaining power was not exercised as strongly in the fall of 2008 and in the year that followed. So this is the benefit of actually at least proposing and undertaking substantive reforms in the missing gaps in the regulation. Then you had a crisis, and as I said, not in the midst of a crisis but right after it.

However, one does need to tackle the sovereign debt crisis problem right away. And my view on this has been it's very important to recapitalize the European banks right away. Not because this is primarily a banking sector problem. I think it's the nexus of sovereign debt and banking sector exposure to the sovereign debt that makes the whole thing pretty complicated.

But it's very clear from the Greek experience that it is the lack of confidence in banks being able to withstand even debt restructuring of a relatively small country such as Greece, which actually procrastinated the entire problem from one quarter to the next since the problems erupted in 2009.

Unless and until we recapitalize the banking sector substantively to give markets the confidence that they don't need to worry about the banking sector while we are doing sovereign debt restructuring, we can't even talk about sovereign debt restructuring. And we keep kicking the can down the road, and we have seen that that only leads to mounting of the debt of some of these sovereigns because they don't have growth and it’s the taxpayers that is required in the short run to meet the liabilities.

The only way they can do it is that the credit markets continue to keep lending to them under the hope that someone else is actually going to be providing the backstop if a default happens in the short term. But as the backstops have not been that credible, perhaps due to political indecision, perhaps because gradually we are now talking about larger and larger countries, in Spain and Italy, it means that the cost of borrowing for these countries is also rising at a dramatic rate.

And so it seems that the current solution of just hoping the problems will go away is not working. So it's better to prepare the banking sector to a recapitalization. And you know, banks in Europe still have equity capital. I just checked about 10 days back. The top 100 banks in Europe had about $1 trillion of equity capital.

If they were to do a deep discount by issue, where you essentially coerce your shareholders to put in equity, and if this equity is required to reduce the debt that they have, especially some of the short‑term debt – and this would be a requirement from regulators so that there's no further adverse signal communicated for the system as a whole beyond the regulators acknowledging that, yes, markets are saying banks need more capital. Yes, we are getting banks to have more capital.

I think this could be a win/win for everyone and it will create more options, politically and for the pan‑European regulators to restructure debt, pass on some haircuts to sovereign debt creditors if needed. It would create options for orderly resolution of indebted countries rather than simply having their debt levels continue to explode at costs which the youth are not going to be able to bear in a comfortable way in the near future.

Viv:  Viral Acharya, thanks very much for taking the time to talk to us today.

Viral:  Thank you, Viv.