Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Thu, 15 Sep 2011

The UK Finish versus the Swiss Finish

The United Kingdom and Switzerland are the two large economies with global banking systems that are far larger than their own economies. Both of them have been worried about the risks that these outsized banking systems pose to their national solvency. They realize that if their banks were to behave as stupidly as the Icelandic banks did, they could face the same fate as Iceland.

A year ago, a Commission of Experts appointed by the Swiss government produced a report on dealing with “too big to fail” banks. A few days ago, an Independent Commission on Banking appointed by the UK government produced its report on improving stability and competition in UK banking.

Both reports have adopted a similar approach in terms of additional capital requirements. For their largest banks, the Swiss report recommended 19% capital consisting of 10% common equity and 9% contingent capital (CoCos). The UK report asks for 17% capital for a large ring-fenced retail banks and 20% for a large investment bank. Again 10% is equity but the balance can be in any form of debt that has “Primary Loss Absorbing Capacity” (PLAC). It is likely that a big part of the PLAC will be CoCos.

The Swiss finish for large banks kicks in for banks with assets of about 50% of Swiss GDP and the 19% capital level mentioned above is reached for their largest banks which have assets of about 300% of Swiss GDP. The UK requirements kick in for banks with Risk Weighted Assets (RWA) equal to 1% of UK GDP and reach the stated level of 17% for RWA of 3% of UK GDP. If we assume that RWA is about a third of total assets, then the 3% level for RWA would correspond to about 9% of UK GDP for total assets. Since UK GDP is about 4 times Swiss GDP, this would correspond to about 35% of Swiss GDP. In other words, the Swiss proposals are calibrated to catch just their two largest banks (UBS and CS), but the UK proposals are much broader. For universal banks which are essentially investment banks, the capital level of 20% is also marginally higher than the Swiss level of 19%. On balance, the UK is going a little beyond Switzerland.

The UK report would allow foreign owned investment banks to operate in London without being subject to the higher capital requirements applicable to UK banks on the assumption that the UK taxpayer would not have any significant exposure to such institutions. The report is really saying that the UK should make money by renting out office space in London to investment banks that may wreck the taxpayers of their home countries so long as the UK taxpayer is spared. “The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so.”

I personally believe that capital levels close to 20% are the right levels. The Rothschilds survived and prospered over two centuries of war and revolution in Europe because they had capital of this level or more (and that too as percentage of total assets and not risk weighted assets). High level of capital did not prevent the Rothschilds from becoming bankers to the world. The Modigliani Miller theorem in capital structure theory assures us that debt is cheaper than equity only because of the tax deductibility of interest. The tax advantage of debt essentially means that levered banks get a subsidy as a percentage of their total debt. If we do want to give tax breaks to the banks, it is better to give it to them as a percentage of assets so that it does not distort capital structure decisions.

The UK proposal goes far beyond the Swiss in another respect – the ring fencing of retail banks. In some respects, it goes beyond even the Glass Steagall Act let alone the Volcker Rule. Ring fenced retail banks are to be prohibited from providing any of the following services:

In another sense, the UK proposal is much milder than Glass Steagall. A ring fenced retail bank and an investment bank can be part of the same group provided the retail bank is independently capitalized and can continue to operate normally even if the investment bank fails and is put into liquidation.

I see some merit in this proposal, but I think it is less important than the requirement for higher capital.

Posted at 22:00 on Thu, 15 Sep 2011     View/Post Comments (0)     permanent link