Banks would fail a real stress test

Our banks are still "too big to fail" and would wilt in a crisis. It's time to end theexcesses of crony capitalism, says Ukip MP Douglas Carswell.

The Bank of England's 2015 stress tests, results of which were released early this month, concluded that "the banking system is capitalised to support the real economy in a severe global stress scenario". After years of taxpayer bailouts, negative interest rates, and new European Union capital regulations, British and European banks are meant to have boosted their reserves. They are supposed to be better capitalised today than in 2007.

But should we believe the hype? The Bank has a vested interest in making the banks look stronger than they are. It is not only the lender of last resort, but determines the price of capital (by setting interest rates), and now wields supervisory authority too. Making Threadneedle Street all-powerful was supposed to create a Leviathan to keep financial order. Instead, it has entrenched regulatory capture theBank has an incentive to overstate the health of the banks, for fear of exposing its own failings.

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Last week, the Ukip Parliamentary Resource Unit published its own analysis. It shows that the banks' apparent strength simply reflects a weak stress test. Part of the problem lies in the global financial regulations the Bank of England is required to use. Both capitalisation metrics imposed by the Basel III regime are inadequate. The first requirement that banks hold a ratio of tier 1 capital (the highest-quality capital) to risk-weighted assets (ie, riskier assets need to have more capital held against them than "safer" ones) equalling at least 7% is a risk in itself.

Agencies and regulators who assign risk to assets have a record of under-reporting risk AAA-rated securities were at the root of the 2008 crisis, for example. And Basel III itself designates EU sovereign debt as zero risk, including Greek debt. So a metric based on risk-weighting is inherently suspect.

The second Basel III capitalisation requirement that banks should have a leverage ratio of common equity to liabilities of at least 3% is better, but insufficient. The leverage ratio cannot be so easily manipulated. But the 3% requirement is far too low to be safe. With such a small buffer, a tiny loss in equity would mean a bank having to sell substantial assets to maintain the ratio.

The EU's inadequate capital requirements aren'tthe only issue. The Bank of England waters down the stress test too, partly by broadening the definition of tier 1 capital to include assets that are far less conservative than regulations intended. Moreover, the stress scenario is far too optimistic applying only the economic shocks that the Bank forecasts. A real stress test should consider the impact of negative shocks that we can't necessarily predict, because central bank forecasts are routinely wrong. Overoptimistic inputs inevitably produce overoptimistic outcomes. In effect, the Bank's stress test is rigged from the outset.

To determine how well capitalised European banks truly are, our paper includes a far more stringent test. Instead of the Bank's forecasts, we used the 2007/2008 shocks as the stress scenario. And instead of risk-weighting, we used the leverage ratio alone as the capitalisation metric. The results showed that major banks are nowhere near as safe as the Bank would have us believe. Under another 2007/2008-style shock, European banks' leverage ratios would fall from around 4% to well under 2%. They would be unable to survive without financial assistance. In short,our test indicated that they haven't been fixed. Major European banks may be no better capitalised now than before the last crisis.

Truly fixing the banks requires much more serious reform than we've seen so far. The key recommendation of our paper is that the leverage ratio requirement must be raised significantly, to prevent over-leveraging. Evidence suggests that, depending on the size of the bank, leverage ratios should be at least 15%.By raising this requirement gradually, functional banks could adjust, while zombie banks could safely be allowed to fail. But dealing with excessive leverage is not enough. Policymakers must also urgently address what causes banks to take on so much debt in the first place: central banks and central government.

"Too big to fail" is a deliberate consequence of monetary, fiscal, and structural policy. Deposit insurance, asset purchases, monetary expansion, and tax exemptions on interest, all encourage high levels of leverage shifting liability from bankers onto taxpayers has given banks an incentive to take risks they would never take if they had to bear the costs. Privatising profits and socialising losses will always result in a dangerously warped financial system.

The real problem is that government has a vested interest in excessive leverage. The exchequer relies on major banks to finance its spending by buying gilts. In return, the banks rely on a regulatory and monetary environment that shields them from the consequences of their bad investments. But this cycle is unsustainable: it has produced crisis after crisis, each worse than the last. Next time, the taxpayer may not be able to bail the banks out. Our research lays bare this worst excess of crony capitalism. Britain urgently needs its policymakers to show the same honesty.

Douglas Carswell is the MP for Clacton (see TalkCarswell.com). The Ukip Parliamentary Resource Unit policy papers are at UkipPolicyForum.com.