United States must clear the air on pollution of bad finance

If other countries want to adopt dangerous forms of money management, America should try to dissuade them. And if that fails, move in the opposite direction.

The megabanks say their capital is replenished and that governments need to ease up on lending rules for growth to take hold. Andrew Harrer / Bloomberg News

By this point in the economic recovery, America's biggest banks had expected the pressure from regulators to abate. In the aftermath of a major financial crisis, there is usually a turn towards tighter rules, and banks naturally build up their equity buffers after near-death experiences.

It is standard practice, at this point in the credit cycle, for bank advocates to claim that a great deal has changed, that lenders have more equity capital than at any time in recent memory and that governments need to ease up on the rules if they want credit to expand and growth to take hold.

This is exactly what leading representatives of global megabanks now say. And there are indications that European regulators are listening, as France, Germany and other nations back away from previously promised reforms.

In the United States, however, there are signs that official thinking is pushing in the opposite direction, in particular towards requiring larger buffers of loss-absorbing equity.

The most recent signal that the US may be on this path is a recent speech by Jeremiah Norton, a member of the board of directors at Federal Deposit Insurance Corporation (FDIC). Mr Norton, a Republican appointee with Treasury and Wall Street experience, joins other leading conservative voices in expressing scepticism about America's banking arrangements.

These voices include the former Utah governor and presidential contender Jon Huntsman, the Federal Reserve Bank of Dallas president Richard Fisher, the FDIC vice chairman Thomas Hoenig, and the newspaper columnists George Will and Peggy Noonan.

Specifically, Mr Norton asks whether the US should continue to rely heavily on sophisticated risk-based measures of assets to calculate the adequacy of what is known as "regulatory capital ratios". Or, instead, should greater emphasis be placed on the simpler, more straightforward measure of "leverage" - meaning how much equity a bank has relative to its assets, without any risk adjustments (or, equivalently, how much debt versus equity the company has on the liabilities side of its balance sheet)?

Mr Norton prefers to focus on leverage, which is simpler to assess and easier to monitor. Risk weights are always wrong, often with dire consequences, as we saw with mortgage-backed securities, collateralised-debt obligations or Greek sovereign debt.

During the 2007-08 financial crisis, Mr Norton said: "the markets rejected the existing Basel risk-based capital measurements in determining a bank's likelihood of default". Yet the latest evidence suggests the banks are again "optimising" their capital, essentially gaming the rules to be able to take on more risk.

The FDIC director also insists that the right measure of capital is equity - built up through retained earnings and by raising cash from shareholders - and not a more complex concept, such as tax-deferred assets. And he thinks banks should have significantly more equity relative to their debts than is currently planned under the Basel III international agreement.

He will find ample support for these positions in The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati and Martin Hellwig. This book is a must-read for anyone interested in finance or concerned about economic policy.

Admati and Hellwig make a powerful explanation of why banks like to borrow too much: It allows them to increase return on equity (unadjusted for risk) in good times, and someone else has to worry about the losses in bad times.

Deposit insurance distorts incentives, creating the need for tough rules for institutions with retail deposits. Those rules, overseen by Mr Norton and his colleagues at the FDIC, have generally worked well since the 1930s.

Unfortunately, today's "too-big-to-fail" implicit downside guarantees for the banks are much more dangerous. The banking lobby denies this safety net exists, even though it is obvious to anyone in the credit markets.

This is a form of government-provided insurance, for which no premium is charged. It distorts the marketplace and is fundamentally unfair to smaller competitors.

The banks involved are very large relative to the economy, and if any were to act irresponsibly, there could be macroeconomic consequences. And even if the downside losses are limited in a narrow financial sense - for example, because the new FDIC-run resolution authority proves effective - there can still be catastrophic implications for growth, employment, the federal budget and much else.

With the US rapidly becoming a bastion of more sensible official thinking, and the Europeans moving in the opposite direction, to what extent should countries aim to cooperate and to coordinate capital standards?

Andrew Haldane, the executive director for financial stability at the Bank of England, suggests that we should think of financial systemic risk as a form of pollution. It makes sense to seek international agreements to limit pollution. After all, smog knows no boundaries.

But if countries on the other side of the world insist on breathing foul air, should the US do the same? Of course not: it should set rules that serve its interests.

In other words, if other countries want to allow dangerous forms of finance, the US should first try to talk them out of it, and then rapidly head in the opposite direction.

Simon Johnson, a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You

* Bloomberg News