Jackson Hole speech and Chilean banks: a cry for simpler and more effective rules

Both The Economist (Buttonwood) and The Wall Street Journal (Editorial) have recently rightly lauded the last presentation given by Mr. Andrew Haldane, Bank of England Director of Financial Stability, at the Federal Reserve ́s Annual Policy Conference at Jackson Hole, Wyoming last August. His paper, co- written with Mr. Vasileios Madouros and tittled “The Dog and the Frisbee”, points to the need for simpler and straight forward capital and leverage regulations of banks as opposed to the apparently safe but convoluted Basel standards. It is a call not to be blinded under the pretended omniscience of regulators or complex bank estimates of values at risk that incidentally could even lack reliable statistical significance and which jointly give a false sense of financial security that has been proven wrong twice in the last five years.

In Chile, no comments have been raised, notwithstanding the fact that the aggregate ratio of assets to equity of its banks is close to 13 times and has been around there for the last five years, whereas in the US it is now close to 8 times, after having coalesced around 12 times before the last financial crisis of 2008. Surely some experience and corrective measures they might have earned and taken, after having lived through a shock that was always statistically possible but that every once in a while could get real. The Eurozone banks are now operating under an equivalent ratio of assets to equity of 12 times. No one would dare state they constitute a solid system as of today. Basel standards failed in the US and have been of no great use in present day Eurozone crisis and have perhaps negatively influenced banks credibility with its sovereign debt accountancy manipulation. Chile has not yet faced a shock as complex as that of the US of 2008 or profound as that of the Eurozone for the last 30 years, a great achievement indeed. But the quarterly statement from its Banking Authority that the financial system continues showing its “historical capital strength” based on Basel I standards is, to say the least, naive. The truth is that our domestic system has not been put to real stress, in terms of a deep economic downturn on a continuing basis during a couple of years. They should better know that overconfidence is lethal and that at present day leverage ratios the country is silently risking macroeconomic growth and stability beyond prudence for shocks do happen. The whole picture gets only worse when domestic pension funds and life insurance companies – themselves extremely leveraged (1) – investments are taken into account for they are important holders of liabilities in the same banking industry through deposits, mortgages and bonds, including subordinated bonds, making risks too embedded and interrelated across the local financial world. Furthermore, they account for over half of the subordinated bonds banks use to improve Basel capital measurements, whereas they should not for their obvious relationship to the other instruments these institutional investors hold on banks.

In “The Dog and the Frisbee” we are reminded that no regulator had the foresight to predict the financial crisis – neither did banks nor economists -; that under uncertainty, as opposed to under risk, it is too difficult to form priors on the probability distribution of future outcomes; that under uncertainty, as opposed to under risk where policy responses tend to be fine tuned, policy responses call for simple decision rules; that simple rules place a heavy reliance on the judgment of the decision maker and on picking the appropriate ones; that landmark 1988 Basel I focused on a limited set of credit risks measured at a broad asset class rather than individual exposure level; that 2004 Basel II introduced the concept of operational and market risk but allowed banks themselves to use internal models to calculate regulatory capital – a regulatory Rubicon crossing -, while dramatically enhancing the asset class levels and risk weights; that 2010 Basel III grew even more complex, thereby increasing opacity; that Basel Accords are non-statutory; that risk based capital was no better at predicting failing banks in the last financial crisis than their simple leverage ratio; that leverage ratios under Basel III are not enough to withstand financial crisis as the one in 2008.

If prudence is any guide and recent external events teach us something, Chilean banks ought to increase their capital to present US ratio of 8 times assets to equity, implying a new aggregate equity of US$ 33 billion from US$ 20.5 billion, under a stringent path. Lowering mutual dependence with institutional investors would not only release funds today captured by banks but would also push them to increase competition for funds and weaken implicit market coordination from too concentrated an industry, while at the same time a central systemic risk would be reduced. The opportune and massive intervention of the Federal Reserve in 2008 deactivated a crisis from taking full speed, but we need to be reminded that too high leverage ratios were an important determinant of its lethality.

Manuel Cruzat Valdés

Santiago, September 25th, 2012

1 See statistics in “En el mundo actual, las entidades financieras necesitan más capital”, August 2012, MCV.

(See annex with statistical series in PDF document)

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