Greed bonanza: bank capital, interest rates and regulation
Central Bank prudential supervision of financial institutions based on the advices from the Basel Committee is one of the three pillars of a stable financial system. The new Basel Committee Leverage Ratio is an additional capital requirement for banks that is introduced after the 2008 financial crisis: banks need a minimum capital (common equity) of 3% of balance sheet total. The leverage ratio functions as a back stop for the risk weighed adjusted capital ratio, the BIS ratio. The in 1988 introduced BIS ratio, allows banks to only hold capital for assessed risks. The financial 2008 crisis has proved that risk assessment is, so to say, a risky business. Banks were very creative in their risk models, resulting in lower capital and levered returns on capital. Bank managers don’t like the leverage ratio because it hurts return on capital and negatively impacts their remuneration packages.
Net interest income (NII) is the main source of income for large commercial ‘too big to fail’ banks: it generates approx 60 – 80% of income. Since 2008, interest rates went to rock bottom low levels. Because the yield curve is sloped upward, banks assets have longer duration than liabilities, or: borrow short and lend long term – a net asset duration mismatch. This mismatch is the main NII contributor. NII benefits from decreasing interest rates and has supported banks substantially to build up the post-2008 crisis additional required capital by central banks. In Europe, most banks now have a leverage ratio of approx 4%. The problem is that if interest rate go up, the opposite will happen. NII will suffer and banks may struggle to cope with required capital levels.
The 2008 financial crisis has a similar pattern as the 1929 financial meltdown: both system crisis occurred after a period of deregulating the financial sector. Deregulation seems the main root that caused these two major crisis. Once the financial sector is ‘free’, it starts to destabilize the real economy by irresponsible risky strategies. It is too tempting: the potential high rewards from more risk starts a greed-bonanza for return on capital, that results in extreme leverage ratios, a multiplied expansion of the financial shadow banking assets and the formation of many ‘too big to fail’ financial institutions, e.g. Royal Bank of Scotland, ING Bank, Dexia Bank, Lehmann and AIG – etcetera. Other evidence for irresponsible bank management is that returns are correlated to risk, and 2007 was a all time high record profit year for the banking industry.
Rising interest rates can uncover that the banks are still very vulnerable and again need tax payers support to prevent a financial system crisis. Banks are still too big, bankers still too greedy and politicians too ignorant. Politicians and central banks need to continue to regulate banks. The 2008 crisis proofs that the 1929 lessons were forgotten and I fear that the question is not if, but when the next system crisis will happen. It might be sooner than expected.