Why banks are riskier than hedge funds

BBC business editor Robert Peston on banking rules

For years, most of us took little notice of our banks - except to moan when we felt they charged us too much or when their service was terrible.

But now we know just how important to all our lives they are.

If they lose a ton of money, we've learned that we as taxpayers have to bail them out, with hundreds of billions of pounds of loans and investments.

And when they get into that parlous state and are unable to lend as much as is needed by businesses and households, they cause a deep dark recession, which impoverishes us.

So it really matters that banks are made safer by new global rules - that were announced only last weekend and which go by the eccentric name of Basel lll, after the quaint Swiss city where they've been negotiated in secret meetings by the world's most powerful central bankers and financial regulators.

What's the verdict on Basel lll?

Well regulators - predictably - say that the rules are tougher than they seem.

They insist that banks will have to hold much more capital - or rainy day money - as a protection against investments and loans going bad.

And the increase in the minimum amount of capital that banks have to retain relative to their loans and investments is in practice considerably more than the headline figures imply, regulators say, because there are tougher definitions of the finance that's eligible to be counted as core equity capital.

Also Basel lll instructs banks to recategorise as much more risky certain kinds of assets held by banks' trading arms - which has the effect of forcing banks like Barclays and Royal Bank of Scotland with large financial trading operations to hold disproportionately more capital.

Are regulators right that these rules will make banks more robust, and won't simply allow them to carry on as before, in effect speculating with taxpayers' money?

Well, little noticed financial disclosures earlier this week by the influential US bank, JP Morgan, on the impact of the Basel lll rules implied that it may not be quite as easy for British banks to meet the new capital targets as many believe.

British banks may be forced to limit their dividend payments for longer than thought, to help them build up their reserves, for example.

And, what's more, British regulators have told me that they may impose even higher capital requirements on the biggest banks - those whose failure would undermine the entire economy.

But when bankers say to me - as they do - that the new rules are hard but fair, you can be pretty sure that they do not represent a fundamental challenge to their way of life.

Here's what concerns many critics of our biggest banks.

The new rules still allow our banks to lend and invest far more, relative to their capital, than a typical hedge fund does

That probably shocks you, because you probably think that hedge funds are the most outrageous speculators on the planet. Well you're wrong about that.

Banks borrow far more than hedge funds do to finance their lending and investing. Their leverage, how much they borrow relative to their equity capital, is typically ten or fifteen times the leverage of most hedge funds: the leverage multiple of a typical bank is 30, compared with between zero and eight times leverage for most hedge funds.

In that sense banks take far bigger risks with their investors' money than most hedge funds do.

So how do banks manage to borrow all this money, and relatively cheaply too, if they are taking such colossal risks?

Well as we've all learned to our cost, if a bank blows up, its creditors can be confident that taxpayers will ride to the rescue - which is palpably not the case for a hedge fund.

Which, some would argue, carries two important implications, if banks want to continue to do business as normal, with an implicit guarantee from taxpayers: first, perhaps banks should reduce the amount they pay out in dividends not just for a few years, but forever; and possibly they should stop remunerating themselves like hedge fund managers.

If banks are making money from the implicit taxpayer support, then taxpayers would presumably want that money deployed to build up banks' capital reserves even more, to protect them against the next crisis.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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