Loosening purse strings

Oct 22, 2012

Three of the major central banks of the world — the Federal Reserve, the Bank of England and the Bank of Japan — have all recently announced further rounds of quantitative easing (QE) in an attempt to boost flagging economies.

Yet despite the huge amounts of money thrown at the programmes, the impact thus far has been limited.  Indeed, far from triggering the inflation that so many opponents of QE have feared, there is evidence that its effectiveness has been diminishing in each round, with growth weaker and inflation lower.

The reason why QE is struggling to work lies in the fact that the banking system is capital constrained. It does not matter how much money you throw at the problem: if a bank has thin capital buffers, it will not be able to grow its balance sheet and therefore it will not increase its lending.

The drive by regulatory authorities to get banks to build up their capital is completely understandable given the disasters that characterised the financial crisis. Some have even argued that the risks run by modern financial institutions are so complex that no regulator can truly understand them, and lower indebtedness and higher capital ratios are the only way to be sure that taxpayers will not have to bail banks out.

However the heavy cost of the drive to higher capital ratios is rarely addressed. We believe it has become sufficiently high that the process has to be at the very least slowed down, if not in some cases reversed.

Modern day capital ratios are calculated by taking the assets of a bank (its loans, bonds and other financial instruments it owns) and multiplying them by a weighting determined by regulators. That weighted balance sheet is then divided by capital, which is normally the bank’s equity and equity-related instruments, to arrive at a ratio.

The European Banking Authority for example has required European banks to boost their tier one capital ratio to 9% by the middle of this year. The recommendations of Basle III and the Independent Banking Commission in the UK will mean still further capital build-up in years to come.

The problem is that there are only three ways for a bank to increase its capital ratio. Raise external capital (normally through selling shares), boost internal capital (by retaining profits) or shrink its balance sheet.

In reality the capital markets are virtually closed to banks at the moment, so option one is a non starter. The call from Andrew Bailey of the Bank of England for banks to do this, at least on any significant scale, is just wishful thinking.

For most banks, profitability is still being hampered by the need to write off bad debts incurred in the financial crisis, which means internally generated capital can only provide part of the answer. That rules out option two.

The final option is shrinking the size of the bank’s balance sheet.
But they cannot increase lending if they are shrinking their balance sheets. That goes especially at a time when regulators are insisting that the banks increase their holdings of assets that are more liquid than loans.

We think central banks were lured into a false sense of security about the effectiveness of quantitative easing from the impact of the first round of such measures. That took place in early 2008 when financial markets were really staring over the abyss and there were worries about the creditworthiness of almost every government.

QE prompted a drop in bond yields, boosted equity markets and allowed credit markets to reopen to companies. The Bank of England’s own research suggested that its own QE added as much as 1.5% to GDP. While we suspect this overstates the impact, because it probably picks up interventions elsewhere (from the likes of the Fed and ECB) we accept that the initial burst of easing was effective.

Recent announcements of new QE have still had a positive effect on bond yields but are more muted, simply because government yields are already very low. They have triggered a rise in equity markets, but again considerably smaller than the first round of QE achieved. Any further sustained impact of such easing has to come from stimulating monetary growth, but that will not happen when banks are up against their capital ratios.

Central banks have recognised that QE is not working to a degree, hence the introduction of the Funding for Lending Scheme in the UK and the decision by the Fed in the US to buy mortgage bonds, rather than Treasuries.

While helpful in lowering interest rates, neither intervention addresses the issue of capital constraint. If central banks really want their policies to work, they will have to work with governments and regulators to stop the drive to shore up banks’ capital ratios.

In this regard, the move by the Financial Policy Committee of the Bank of England to advise banks that they can have some flexibility on their capital ratios to increase lending and to loosen the liquidity requirements are a step in the right direction.

It is the first sign that the authorities have begun to realise that the drive to higher capital ratios has been hurting the recovery. We hope that this new pragmatism is the start of change in policy by regulators around the world.

This article originally appeared on The Times’s website (£)

Author

James Barty

James Barty
Senior Consultant to Policy Exchange, Financial Policy, 2011-2013 Read Full Bio

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