Bank lending to private companies in the UK has fallen in every single year since the financial crisis, dropping a staggering £57 billion since 2008. That decline continued last year despite the introduction of the Funding for Lending Scheme.

Capital Requirements: Gold plate or lead weight? says that the primary reason for this lack of credit is due to the financial regulator’s desire to raise the capital requirements of UK banks. If banks have to raise their capital ratios they can do so by raising capital in markets, retaining profits or shrinking their balance sheets. With financial markets virtually closed to banks and profits under pressure they have been forced to make the adjustment through lending. While some adjustment was necessary the continued drive by the Bank and the FSA to force the banks to raise capital ratios has backfired. The lack of credit growth that has accompanied it has destroyed the Bank of England’s attempts at easing monetary policy through Quantitative Easing (QE). It is this financial austerity that has really stalled the economic recovery.

The paper argues that the root cause of the financial crisis was a regulatory regime (Basel 2) that, through its low allocation of capital to highly rated securities, encouraged banks to not only issue those securities but also hold them on their own balance sheet. Basel 2 encouraged a reliance on ratings agencies at the expense of credit analysis. It also favoured secured lending where bankers and regulators did not look hard enough at the underlying asset.

The only common feature amongst all the banks that blew up, in UK and overseas, was that they took poor risk decisions. That was as true of Bradford & Bingley and Northern Rock as it was of RBS and Lehmans. Interestingly most of them met the Basel 2 capital requirements at the time they were either rescued or failed.

• In the United States, low capital weightings of mortgage backed securities made these investments attractive to banks. US commercial banks held three times more of these assets than other US investors who were not governed by Basel 2.
• Similarly, in the UK, RBS and HBOS had taken on a lot of mortgage backed securities even though these were safe bets and AAA backed. But the UK banks also made appalling risk decisions in their traditional lending business, particularly in commercial real estate.

The report says that much of what has been done to make changes through Basel 3 is sensible and does alter the balance of the regulatory regime in the right direction. However, where the rules are misplaced is the underlying concept that safer banks necessarily make a safer financial system. A financial system that cannot provide the credit to allow an economy to grow is not a safe financial system. It causes the economy to be weaker.

The report recommends ways to encourage lending:

• Allow banks to run down their capital ratios
  • Basel 3 demands minimum Common Equity Tier 1 ratios of 3.5% rising to 4.5% in 2015 and Tier 1 capital of 4.5% and 6% by 2016.
  • The UK banks all hold capital well in excess of these levels, with RBS at 7.7%, Lloyds at 8.1% and Barclays at 8.2%. Rather than forcing the banks to raise extra capital to boost their buffers the Bank of England should encourage the banks to use their excess capital to lend.

• Rather than electrify the ring-fence we would allow it to be as flexible as possible
  • The UK is the only European country that is looking to put in place a fully fledged ring-fence. The ring-fence will already cost banks more to fund and implement, and requires even more capital. If it is not made flexible enough it could damage the competitiveness of the banking industry and further restrict credit supply.