Curbing risks of big banks

China forum Xiao Gang

Global systemically important banks must fulfil their new requirements to ensure resilient world financial system

While the world kept a watchful eye on the results of the G20 summit in Cannes, France, with respect to the European crisis, it is important to note that the leaders of the G20 formally endorsed the list of 29 “global systemically important banks” (G-SIBs).

Recognizing the fact that neither low inflation and stable macroeconomic environments, nor micro-prudential supervision of individual institutions are enough to maintain financial stability, the 2009 London G20 summit launched the initiative of establishing a macro-prudential policy framework and accepted the concept of designating G-SIBs.

Despite heated debates on the process over the past two years, the selected G-SIBs will face a new and more intense regulatory environment, and will be required to have more capital and liquidity.

There is no doubt that failure or distress of a large or complex financial institution can have a greater impact on the financial system than a smaller, simpler institution. Hence, those institutions must have more capital to absorb losses and be subject to greater supervision, making it possible to close or restructure them if necessary without massive disruption to the rest of the financial system. In this way, no institution is too-big-to fail or too-connected-to fail.

Obviously, without a global framework for handling cross-border bank bankruptcies, the world economy is still vulnerable to a repeat of the disastrous collapse of Lehman Brothers in 2008.

The methodology with which G-SIBs were identified is based on size, interconnectedness, substitutability, global activity and complexity. Such banks clearly can have a greater impact on the real economy, job creation and financial stability. However, since the mid-20th century managerial capitalism has been transformed into global financial capitalism and financial products and activities have exploded dramatically and become far removed from the real economy. For example, the assets of British banks now exceed 6,000 billion pounds ($9,654 billion), while lending to UK businesses — to farmers, manufacturers, retailers and construction companies etc — accounts for only about 3 percent of that total. Most of assets of UK banks represent financial institutions trading with each other. Such over-financialization should be adjusted, and the banking system returned to promoting the real economy.

There are worries that an increase in the minimum capital requirements for the G-SIBs may raise their costs and reduce their willingness to lend, further deepening the global recession. But the G-SIBs can meet the more stringent ratio requirements either by raising fresh capital or by shrinking their assets and should be carefully monitored to ensure they meet the new requirements and take the appropriate measures to change business models and adjust assets portfolios without any adverse knock-on effects to the real economy.

A transition period is necessary for banks to build up their capital base by retaining earnings, raising new capital, limiting dividend payments and keeping a cap on executive compensation.

After all, the long-term negative impact of higher capital on economic growth is relatively small, and the benefits far outweigh the costs. According to some studies, the balance of the benefits and costs of higher capital ratios peaks at a level of between 10 to 11 percent. G-SIBs must be responsible for preventing systemic risks from happening in global financial industry. A leverage ratio (Tier 1 capital/adjusted assets) introduced by Basel III forces banks to hold more liquid assets and cut back any reliance on short-term funding. This is an important instrument to curb excessive expansion and risk-taking so as to help contain the build-up of systemic risks. Moreover, as a backstop to banks’ capital, the leverage ratio can guard against possible miscalculations of risk during booms.

Fundamentally, G-SIBs can ensure their survival if they operate prudently. Although financial crises have had many complicated reasons in the past decades, often they are the result of banks lending money they shouldn’t have lent to borrowers who shouldn’t have borrowed. Borrower demand is almost certainly a bigger problem than lender supply.

The Royal Bank of Scotland is good case study. After 17 months of investigation, the UK regulator has concluded that no rules were broken by those who took the bank to the brink of disaster, what went wrong was the near-fatal decision to expensively acquire ABN Amro, largely with borrowed money, just before the global financial crisis.

The endorsement of the G-SIBs made by the G20 is a good start for establishing a new global regulatory framework. But there are a lot of things to be done to ensure its successful implementation. Given the eurozone crisis and the faltering world economy, different countries of course have different policy priorities, but maintaining the global financial stability that is so crucial to the world economy must be a common goal for the long-term.

The fact that the Bank of China, a 100-year-old bank, was included on the list of G-SIBs not only represents the bank’s international brand identification, it is also a recognition of the progress made in Chinese banking reform during recent years.

As the only G-SIB selected from emerging market economies, we are committed to undertaking greater responsibilities in supporting the economy and maintaining financial stability. That will surely bring many opportunities and challenges to our bank for further transformation, driving us to continue to innovate financial services, improve corporate governance and to strengthen both risk and human resource management.

Right now, all G-SIBs are allocated into four buckets with different requirements related to additional common Tier 1 equity — ranging from 1 percent to 2.5 percent of risk-weighted assets — Bank of China is in the last bucket with a capital surcharge of 1 percent, and its current capital adequate ratio has already met the requirement, so the impact on the bank is limited.

The world needs a safer, resilient financial system for promoting strong, balanced and sustainable growth, and thus the G-SIBs must undertake more responsibilities and make more contributions to the system