Most people are familiar with the tale of the boy who cried wolf. A bored shepherd amuses himself by crying wolf when there is no wolf. He does so twice and villagers come rushing to help each time, only to find there is no wolf.
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When the boy cries wolf a third time, the villagers think he is lying to them once again and ignore him. But this time, a wolf has indeed set upon and scattered the shepherd's flock.
The chorus of bankers complaining that onerous capital requirements are holding back the global economic recovery by constraining their ability to lend is a reminder of Aesop's tale. Two banking and finance academics, Anat Admati and Martin Hellwig, debunk the banker's cry of wolf in their book The Bankers' New Clothes.
Capital regulation is concerned with the composition of a bank's liabilities - these are the funds raised from shareholders, wholesale debt markets and customer deposits to fund its lending activities.
Prudential regulators simply force banks to have a minimum amount of shareholder equity or loss-absorbing capital. Equity acts as a buffer or shock absorber in the same way a large deposit better shields a home owner with a mortgage in the event that the value of their house declines.
Capital regulation does not require banks to set aside capital to sit idly in their vaults. The bank retains complete discretion over who it lends to, how much and on what terms.
The new Basel III capital rules being rolled out globally have introduced tougher requirements, and bank regulator the Australian Prudential Regulation Authority has imposed even higher capital ratios than recommended under the Basel III rules.
However, the leverage ratio for Australia's major banks remains less than 10 per cent. This means for every $100 of loans written by the Australian banks, they hold less than $10 of equity. In contrast, non-financial companies listed on the ASX typically fund themselves with 50 per cent of equity.
Isn't it troubling that banks are prepared to lend to businesses only at significantly lower levels of gearing that they enjoy themselves?
Banks that fund a greater share of their loans with equity are regarded as safer and should be able to better withstand a run or a financial crisis. Why, then, don't banks hold more equity capital?
The answer is simple: taxpayer-funded deposit guarantees encourage financial institutions to take on excessive risk. The lure of cheap debt funding is too tempting for bankers and trumps any systemic concerns that high leverage could undermine the stability of the financial system.
The federal government has asked the financial system inquiry to evaluate how financial risk is allocated and systemic risk is managed. But as long as governments and prudential regulators around the world continue to heed bankers' cries of wolf, capital ratios will remain dangerously low.
Against this backdrop there is a growing risk that another crisis of confidence could once again expose the fragility of the global financial system.
The author is a former stockbroking analyst and funds manager.
