A regulatory shake-up that would give central banks too much power

Investing

The writer is a founding partner of Veritum Partners

The life of an analyst of bank stocks is not for everyone. Much of the day is spent wading through regulatory minutiae, maintaining bloated spreadsheets and hacking through a thicket of acronyms such as CCBs, CCyBs, G-SIB, ATI, Pillar 2 etc.

A recent speech by a senior UK regulator has proposed making things simpler, perhaps too simple though. Sam Woods, deputy governor for prudential regulation at the Bank of England and chief executive of the Prudential Regulation Authority, laid out a vision of a new system of regulation for bank capital.

On the face of it, this sounds like an excellent idea, but it could actually have worrisome repercussions, further extending the arguably outsized power of central banks in markets.

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This power and influence has already been extended by central bank interventions over the past decade to rescue economies through unprecedented asset buying. The changes suggested by Woods would mark a further encroachment.

The amount of capital a bank needs drives almost all its key decisions: how much it can lend to customers, how much it can spend on acquisitions and how much it can give to shareholders via dividends and share buybacks.

The rule book governing the amount of capital banks need is highly prescriptive and detailed, and has become more so over the years. The original Basel I rules governing bank capital — formulated in the 1980s — ran to 8,000 words; the most recent iteration, Basel III, is more than 200,000 words. There is, of course, a role for regulators to add in their own requirements, but the building block is this detailed external rule book.

In Woods’s reimagining, the regulator would simply set a bespoke, single capital number for each bank. While there would be an average level of capital that the average bank would need, for each individual bank the regulator would tell the bank to have more or less than that average. And that required number would be fully disclosed. Thousands of pages of complicated rules and impenetrable acronyms would be consigned to the dustbin.

This is not without appeal. One of the biggest challenges for banks is understanding the rule book. And for investors, it is nearly insurmountable. Not having to understand all the current rules and exotic-sounding acronyms would not only save a lot of time and trees but might even make banks more accessible for investors and hence more investable.

Wood’s suggestion also builds on a tradition at the BoE of being wary of overcomplicated regulation. Indeed, in a speech a decade ago, Robert Jenkins, then a member of the FPC, suggested a deal with banks whereby the regulatory rule book would be rolled back in return for banks having capital equivalent to 20 per cent of assets.

But there are many risks to having regulators simply set individual capital requirements for each bank without a rigid framework. Most obviously, it relies on regulators getting it right. Without a detailed, prescriptive rule book, it would now be down to regulators to exercise their judgment on, for example, the risk profile or the strategy or the business prospects or the governance structure or even the culture of each bank, assessing how each factor affects the profitability and risks and, therefore, how much capital the bank needs. And that is before worrying about litigation from getting things wrong.

And there is another angle to this that could have worrying consequences. Many investors are scared of investing in banks because they are massively leveraged and highly complex. A regulator stating, for example, that Barclays needs a higher capital ratio than Lloyds Bank as a result of its own judgment — formed in part with non-public information — is effectively publicly commenting on each bank’s prospects and risks. Arguably, it is close to a sellside analyst giving a buy or sell recommendation, but with inside information. In effect, investors may end up outsourcing their investment decision to the regulator.

The current rule book is way too complicated and attempts to simplify it should be welcomed. And of all the possible participants, the regulator is perhaps best placed to fully understand a bank in a way that, for example, external investors cannot.

But giving the regulator such judgment in deciding how much capital a bank needs without the tramlines of a detailed rule book gives regulators extraordinary powers that it is far from clear they have the bandwidth to fully discharge.

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