Escaping banking’s vicious circle

The crisis has led to many banks worldwide suffering losses. And yet, they cannot raise new equity capital in the marketplace since investors fear the health of the banks may deteriorate further. In order to respect their solvency ratio (Basel 2), they are therefore forced to reduce their assets so that they again meet the maximum regulation multiple return (12.5 times) of their equity capital. So governments are intervening by going directly into the banks’ capital, supplanting the market and so counteracting as best they can a credit “crunch” which would be otherwise inevitable.

If this sequence of events is familiar, Basel 2 provokes another one sequence less well known, however dangerous. Even when the banks are not at a loss, when times are rough they are driven to reduce their credits and their market positions. The financial and economic crisis triggers an increasing effect on the calculated value of the banks’ assets. It is not the occurrence of nominal assets but of assets weighted by the risk they represent (risk weighted assets or RWA). This risk is measured by volatility of the positions in the financial markets, and by the probability of failure in the case of credits. In both cases the calculation of risk is based on the events of the recent past. The observation of the price drop in financial assets and of the increase of their volatility raises the value of their weighted assets by their risk and thus leads to the increase of the required level of their equity capital. At the same time, the deterioration of borrower’s grading caused by the economic crisis mechanically increases the value of banks’ risk weighted credits, and so too their need for equity capital. And yet if, because the stock market doesn’t allow it as is the case today, the banks cannot manage to increase their equity capital to re-establish their ratio, they can only reduce their market positions by selling a portion of their financial assets. In doing so, they worsen the drop in the markets and their volatility, so provoking a new increase in their risk value. In the same way, on the credit side they cannot reduce their borrowings and so de facto they further weaken the economic agents, and the risk value of existing credits. It is here that at this point the vicious circle is perfectly complete!

Of course, faced with this risk of endless deterioration of asset prices and the economy, the Governments have thankfully reacted very quickly by directly investing in banks’ capital or by guaranteeing some of their assets at risk, or more precisely by buying these assets directly. This is absolutely necessary but the action which would help to break the vicious circle at the very moment that it is formed would be to urgently revise the methods of calculation of risk to the banks’ assets, by stopping their worrying procyclicity since they are largely based on recently observed risks. Or instead, by conserving the same methods, to adjust the required level of equity capital in an anticyclical way against the assets calculated in this way. Although today, while the economy and markets are doing well, the banks can take more and more risks with unchanged equity capital, thus strengthening the possibility of a boom. And conversely in the event of a reversal of speculation and the markets. It would clearly be preferable to progressively demand more equity capital since everything improves and maintains the same conservative level when everything deteriorates as it has today.

Even if that is insufficient, this necessary reform requires an international agreement, whereas the Governments intervene nationally. This is why the scope of the current crisis is forcing Governments to act without delay. However, with a certain parallelism, the IFRS standards which themselves are strongly procyclical have been significantly softened as soon as the end of 2008. And yet the urgency for a revision of prudential standards is also imposed. The progressive nationalisation of banks or the investment to their equity capital of funds borrowed by the Governments themselves is obviously essential but cannot be a long-term solution. It must be combined with a conservative structural reform of the calculation of bank equity capital required by Basel 2.

Olivier Klein
Professor of Financial Economics at HEC and
Bank’s CEO

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