Doing a Harold Wilson

Just over three years ago coalition Prime Minister David Cameron promised there would be a referendum in the UK to remain in the EU or to leave it. He told colleagues that he was determined not to "do a Harold Wilson," referring to the previous 1975 referendum. On that occasion the Labour Prime Minister had negotiated meaningless and trivial "concessions" from what as then the EEC, but had claimed they represented a substantial change in the relationship the UK would enjoy with the rest of the EEC if it voted to stay. The UK voted heavily to remain, and the "concessions" were revealed to be inconsequential as the drive to concentrate more powers to the centre of the European project continued. UK voters thought they were voting to remain in an economic community, but they found themselves bound to what was increasingly a political union, indeed, one that changed its name to the European Union.

Despite his awareness of Wilson's action, and his determination not to repeat it, David Cameron appears to have done so. The renegotiation was not supposed to be about benefits and immigration, but about the fundamentals of the UK's relationship with the EU. It was supposed to be about the UK regaining ability to decide its own laws instead of having to accept ones decreed by the EU as a whole.

It is noticeable that the 'deal' - hailed at the time as an historic breakthrough - has scarcely been heard of since. Those campaigning to remain in the EU have hardly mentioned it, and the debate has simply been about whether the UK should remain within the EU as it is presently, or should leave. There is no status quo option. A vote to leave would engender some uncertainty, but so would a vote to remain. It would be a vote to remain within an EU committed to "ever closer union, with all the future uncertainties that this implies. The issue this time is not a vote about trivial "concessions." It is about UK sovereignty.

A fascinating question in The Guardian

A fascinating question in The Guardian to which we have the answer.

Where now are the earthly paradises from which an idealist can take hope?

Well, yes, where?

With Barack Obama on his way to a changing Cuba, the left is fast running out of countries to revere

In our lifetimes the answer, which country should the British left look to as the example of the good society, has changed. From the various Soviet abominations, through Nicaragua, some have more lately looked to Greece, to Argentina under the Kirchners, possibly to Brazil and Venezuela. There was a brief moment when Pol Pot was the man although that little embarrassment is generally smoothed over now. And of course Cuba's totalitarian poverty has always been there as a goal.

Yet if we were to rerun matters from when socialism was first thought of as a reasonable method of organising society, say the 1870s or 1880s, we'd have to admit that none of those places have done as well as the North Atlantic countries that almost all of us reading here inhabit. The largely capitalist, largely free market, economies are those that have delivered that list of wants and desires. Free at the point of use education, health care. Cheap food for all, the UK is currently falling down a bit on decent and cheap housing but most of Europe manages it. It is possible in our current day and age for a human to flourish as no other groups of societies have ever managed to permit, let alone allow or encourage.

That is, if we think of the stated goals then the road to that socialist paradise is some version of the capitalist free marketism. And we're really not all that sure how important the capitalist part is, even though we're entirely adamant that the free market part is vital. Because almost all of the disasters of those socialist attempts have come from the attempts to destroy markets rather than the simple nationalisation of the means of production.

There are of course possible variations within this system. The Nordics do rather more taxing and redistributing than we do for example. They are also notably more free market, robustly so, than the US or UK. But the end result of our 150 years or so of experimentation seems to be that if you want to make the common man better off then you're restricted to that narrow band of policy choices somewhere between classical liberalism and social democracy. We've tried almost all of the other schemes out there in one place or another and none of them have worked. Corporatist fascism doesn't, anti-marketism doesn't, the various flavours of socialism lite don't and the attempt to get to communism was a disaster everywhere.

That is, if you want to create utopia you really ought to have the gumption to note that by any historical or global standard, you are standing in it. Nope, it's not perfect, we too can find things that we think can be done better. We can even think of radical policies that we would hope to see enacted: but the basic underlying structure of a society that works seems to have been proven. Let the market rip and tidy up around the edges as much as you desire. Tax it more or less heavily as you wish to redistribute. We would tax less than others, they would redistribute more than we. But if anyone really does want to lay claim to the title of "scientific socialism" then it really is necessary that they take account of the evidence.

What actually can we prove works? A largely market, even free market, society with some level of taxation and redistribution on top of it. Nothing else does seem to.

So we don't need the BBC any more then?

We're being told that the BBC is really on a roll with their drama productions:

Whether it is down to Tom Hiddleston’s clean-cut good looks, John Le Carre’s scintillating plot, or the cinematic qualities afforded by its blockbuster £20 million budget, the show is a bona fide hit, to the delight of executives at Broadcasting House, the BBC’s central London headquarters.

Following hot on the heels of War and Peace, another lavishly-funded Sunday night epic, the corporation is currently enjoying a purple patch in drama, which insiders credit to a decision by Lord Hall of Birkenhead, the director-general, to raid tens of millions of pounds from the budgets of other departments, funnelling licence fee cash into the genre.

Super, isn't it lovely that the taxpayer is getting something for their scalping? However, not that this is what they think they're saying, even the BBC agrees that this is no longer necessary:

Lord Hall describes it as a “flight to quality”, and says that the corporation cannot hope to match the spending of an organisation such as Netflix, which plans to spend $5 billion (£3.5 billion) on original commissions this year.

“We can’t win against a Netflix or an Amazon, because their budgets are just so much bigger,” he says.

The argument in favour of the, or even a, BBC is that it provides something the market unadorned cannot or will not. Might be the scale, might be the type, but something that competition will just not produce. And here we have the BBC stating that not only can that market produce those goods, they produce them better than the BBC does.

At which point there is no argument for the BBC to be doing these things, is there? Or, perhaps, any things?

It's not obvious that the new Libor will be better than the old Libor

In a political sense it is obvious that the old way of calculating Libor had to change. But in the more economic, or even financial, sense it's not wholly obvious that this new method is going to be better. We've made this point before but there were actually two manipulations of that benchmark interest rate. One was varied traders trying to get their own bank to shade it one way or another in order to benefit their own trading books. This produced minor swings one way and another and the major losers were the trading books of other traders. Further, given that quite a lot of people were doing it the manipulations cancelled out to some extent (and if all had been doing it then there would have been no effect). The second was perhaps more serious although isn't what has been prosecuted. In the depths of the crash, when there wasn't in fact any interbank activity, Libor was still being reported as being reasonable. When, in fact, in the absence of there being any such lending, and no one would offer it even if someone asked (that being our entire problem, that the interbank market froze), the true Libor was somewhere up around infinity.

We're actually rather glad that second manipulation took place.

Still, politics being what it is the calculation method has to change:

Each day a group of banks publish the average cost at which they can borrow money from other banks. The measure was founded in the 1980s and grew in importance in the following decades.

But in 2012 it emerged that a series of banks’ traders had lied in their submissions, either to improve their own trading positions or to flatter the banks’ own financial position.

As a result the British Bankers’ Association surrendered its administration of the index, and the IBA took over.

The new system means the IBA’s computers are plugged directly into banks’ trading systems, and will record their transactions and so calculate Libor from actual market data.

The problem here is that not all of the banks on the reporting panel transact in all the Libor currencies and maturities on any particular day. They might well trade instruments, sure, but they don't all borrow across all those variants each day. There's thus something of a paucity of market information to be calculated. And if that interbank system freezes again, as it might well do in the next (yes, there will be another one someday) financial crisis then are we happier with the idea that reported rates will be soaring to infinity?

It's an interesting problem to which we have no ready answer. Is it better to rely upon the professional judgement of possibly corruptible experts or upon incomplete market information? If we had complete market information then it's obvious, but incomplete?

Of all the disability cuts, this week's may be the most sensible

It is often baffling how some Budget measures cause outrage while others pass by barely noticed. We all remember the furore about the tax credit cuts. But how many people remember that the same cuts will be applied to Universal Credit, which is replacing tax credits? This week’s cut to the Personal Independence Payment (PIP) is another example. Jeremy Corbyn denounced it as punishing “the most vulnerable and the poorest in our society”. The ink had barely dried before Tory backbenchers made clear their disagreements with the Chancellor. But of all the cuts that the Conservatives have made to disabled people, the cuts to PIP may well be the most sensible. They are almost certainly the least damaging.

PIP is not a means-tested benefit. We may think that this is a good thing  – especially those of us who support a basic income. But it is wrong to say that the PIP cut targets the poorest, as many have.

It’s also unlikely that the most vulnerable will be affected by the PIP changes. To give some context, the PIP application consists of a questionnaire. Claimants are assessed and acquire points based on their ability to do certain tasks with or without help. For the “everyday living” component, there are 74 points available. If a claimant gets 8 points, they receive £55.10 per week. Someone who gets 12 points will receive £82.30. Currently, needing “to use an aid or appliance to be able to dress or undress” and needing “to use an aid or appliance to be able to manage toilet needs or incontinence” are each worth two points. In the future they will be worth one point each. An aid or appliance could be a grab rail in the bathroom or something to help with putting stockings on.

By design, if the loss of one or two PIP points will cause someone to lose money, that person is not severely constrained in their ability to cope with everyday living. That is not my judgement. The criteria and scoring matrix are readily available online.

So, 600,000 people may be affected in the sense that they lose a PIP point. That does not mean that 600,000 people will lose money. Surely it should be the pound in the pocket that we care about, rather than the PIP point on the paperwork?

The people featured in news reports as potential losers will probably have plenty of PIP points.

So, the PIP changes aren’t nearly as bad as what the outrage would suggest. They may even be a good thing if they allow funds to be targeted to those disabled people who face the highest additional living cost. If Osborne is so determined to salvage his fiscal rules, he may have had to cut something else other than PIP – potentially something that would been even more damaging to disabled people.

I find it very hard to understand why, after all the welfare cuts that disabled people have faced, it is the PIP changes which have resonated.

We’ve had the Work Capability Assessment, which ignores any debilitating side-effects of medication; the Bedroom Tax – an attempt to cure under- and inelastic supply of housing (caused mainly by a failure in central planning) with a tax on people who would love to downsize but can’t find anywhere to move to – and a failing sanctions system that can see people punished for attending job interviews or medical appointments. There has certainly been a lot of outrage about these, but why has it not been effective?

Why – only last week – did the same Tory MPs who are now upset about PIP vote to cut £30 a week from Employment and Support Allowance claimants who are in the Work-Related Activity Group? These are people who have been judged unfit for work. If they were fit for week, they’d have been moved on to Jobseekers’ Allowance. But they haven’t been written off either; if there was no prospect of them being able to work, they’d be put in the ESA (Employment and Support Allowance) “Support” group.

They’ve been found fit for “Work-Related Activities” (WRA). By definition, they cannot work. By definition, they are too ill to seek a job. WRA could be joining a waiting list for, then attending an NHS course of cognitive-behavioural therapy. It could be to undergo some physiotherapy on the NHS. It could be some basic training. It is most certainly not looking for a job. So, ESA WRAG ("Work-Related Activities Group") claimants will likely remain on the benefit for far longer than JSA claimants. Is it too unreasonable that they should receive a bit more than the JSA rate?

ESA WRAG is means tested after 12 months. ESA claimants are too ill to even look for work. By definition, those affected by the ESA cut are the ones who are “the poorest and most vulnerable in society.” But who cares?

The Budget saw a tax cut for the middle classes funded by one of the only welfare cuts yet to affect the middle classes. And we are all up in arms about it.

I missed the Owen Jones event at the ASI last week, and I don’t have my signed copy of Chavs to hand so I can’t quote directly. But there’s a whole chapter about why policymakers and opinion-formers focus on what affects the middle-classes, and not the poor who are mostly hidden from view.

Maybe libertarians can learn from this. Especially when we believe that free markets and small government will be helpful to the poor.

FULL DISCLOSURE: Several of my family have claimed various disability benefits. Some still do. I claimed Disabled Students’ Allowance while at university.

No to council housing, yes to housing benefit

That we have something of a housing problem in the UK is obvious. That we should be doing something about it equally so. However, those who tell us that we should be building more council houses are wrong. Yes, obviously, build more housing to bring the price down (by releasing more land to build upon) but housing on council tenancies is just the wrong way to go:

This paper provides new evidence on the effects of moving out of disadvantaged neighborhoods on the long-run economic outcomes of children. My empirical strategy is based on public housing demolitions in Chicago which forced households to relocate to private market housing using vouchers. Specifically, I compare adult outcomes of children displaced by demolition to their peers who lived in nearby public housing that was not demolished. Displaced children are 9 percent more likely to be employed and earn 16 percent more as adults. These results contrast with the Moving-to-Opportunity (MTO) relocation study, which detected effects only for children who were young when their families moved. To explore this discrepancy, this paper also examines a housing voucher lottery program (similar to MTO) conducted in Chicago. I find no measurable impact on labor market outcomes for children in households that won vouchers. The contrast between the lottery and demolition estimates remains even after re-weighting the demolition sample to adjust for differences in observed characteristics. Overall, this evidence suggests lottery volunteers are negatively selected on the magnitude of their children’s gains from relocation. This implies that moving from disadvantaged neighborhoods may have substantially larger impact on children than what is suggested by results from voucher experiments where parents elect to participate.

This is over and above the well known finding that labour immobility reduces employment levels. And in the British housing market there's nothing so immobile as a council tenancy.

We're always going to have some form of housing subsidy for those who simply cannot manage themselves. But it should be a subsidy simply paid out, not the creation of estates of immobile people.

Business rates are a tax on landlords, not on businesses

There is such a thing as a bad tax cut, and business rates relief for small businesses is one of them. Despite what the Chancellor claimed in his budget yesterday, reducing rates will likely be a tax cut for landlords, not businesses. Business rates are a tax on non-domestic property, paid by the occupier rather than the owner and based on the property's rentable value. Since they are paid by the renting business, most people assume it is businesses who lose out because of them.

In fact, the burden of the tax seems to mostly fall on the property owners, not the firms occupying them. This is because when rates are cut, rents rise in proportion to that cut. Lower rates means higher rents. That means that the level of business rates makes no difference to the operating costs of businesses that rent their premises, and cuts to business rates will end up giving money to landlords, not business.

The theory, at least, goes like this: Because supply of land is fixed, the total rental value of a property is determined entirely by demand – how much would-be renters are willing to pay to rent there.

Firms think in terms of the total cost of occupying somewhere, and the division between rates and rents is not relevant to them. They don’t care who gets the money, they care about how much it costs, all in all, to be located somewhere. When the amount they have to spend on rates rises, the amount they can spend on rents falls. When rates fall, the amount they can spend on rents rises.

This theory is borne out by empirical evidence. In 2003 Dr Nigel Mehdi looked at the introduction of the Uniform Business Rate in 1990, which replaced property taxes that differed greatly before then. He found that, across London, property values adjusted so that total occupancy costs between matched properties equalized over time. In other words, where rates fell, rents rose; where rates rose, rents fell.

The Institute for Fiscal Studies’s 1996 paper “Who Pays Business Rates?” looked at the same event on a national level and produced a similar finding, in the long run.

But how long is the long run? In the time it takes for rents to rise (as old rental agreements expire and new ones are made), businesses will capture the reduction in rates. But this may not be very long. A recent paper by the British Property Federation looked at five revaluations between 1990 and 2010 and found that within two to three years 75% of the value of a business rates change had been factored in to rents.

So while we should expect this business rates exemption to fairly quickly be offset by higher rents, how does the fact that small businesses only are exempted factor in? I’m less sure about this, but I suspect we may see a similar effect to what happens with Housing Benefit. Rents will rise overall, but recipients of the exemption (small businesses) will end up being slightly better overall. Unfortunately this comes at a cost to other businesses, and most of the benefit will go to landowners.

There is also the “Francification” problem of having hard cut-off points for business benefits based on their size (which the small business exemption does, based on property values). Hard cut-offs lead to situations like France’s where firms cluster at the cut-off point – the chart above shows how many firms have restricted themselves to 49 employees to avoid all the legislation that kicks in for ‘big’ firms with 50 employees or more. The second problem is that small businesses are not inherently better than big businesses, and benefiting them at the expense of larger firms is likely to be wealth-destroying overall.

Business rates are bad mostly because they tax the property value, rather than the underlying land value, so they disincentivise investment in better property or machinery (when that machinery is rateable). A wise Chancellor would move rates to being a tax on the land value alone, and skip the destructive gimmicks like this one.

Osborne's disastrous sugar tax decision in the Budget

George Osborne made a truly horrible decision in the Budget yesterday: the one about a sugar tax.

So today I can announce that we will introduce a new sugar levy on the soft drinks industry.

Let me explain how it will work. It will be levied on the companies. It will be introduced in two years’ time to give companies plenty of space to change their product mix.

It will be assessed on the volume of the sugar-sweetened drinks they produce or import.

There will be two bands – one for total sugar content above 5 grams per 100 millilitres; a second, higher band for the most sugary drinks with more than 8 grams per 100 millilitres.

Pure fruit juices and milk-based drinks will be excluded, and we’ll ensure the smallest producers are kept out of scope.

We will of course consult on implementation.

We’re introducing the levy on the industry which means they can reduce the sugar content of their products – as many already do.

It means they can promote low-sugar or no sugar brands – as many already are.

They can take these perfectly reasonable steps to help with children’s health

Of course, some may choose to pass the price onto consumers and that will be their decision, and this would have an impact on consumption too.

We understand that tax affects behaviour. So let’s tax the things we want to reduce, not the things we want to encourage.

It's not that taxing sugar is a particularly bad thing to do. There's other nice and desirable things that we tax like booze and insurance. Hey, got to get the revenue where you can.

Rather, what worries us is the monumental mountain of lies that the campaign for this tax has been built upon. Sugar consumption has been falling in recent decades even as the country gets ever porkier. It is therefore not sugar consumption driving the fact that we're all becoming lardbuckets. If that is so the tax won't achieve the stated goal.

However, what will happen as a result of giving in to the misinformation being shouted from the rooftops is that every Single Issue Fanatic will now be concocting plans to bombard us, and more crucially the government, with demands for whatever absurdities they can conceive of imposing upon us. Whatever the actual merits of a sugar tax (none, but that's by the by) the caving in to the fanatics has just made future public policy worse.

Just not a good idea.

The Adam Smith Institute's reaction to the 2016 Budget

Commenting on today's Budget, spokesmen for the Adam Smith Institute said:

Today’s budget was disappointing. Growth forecasts have been lowered, and the Chancellor’s failure to deliver any kind of growth agenda in the last Parliament has left the British economy vulnerable to a global economic slowdown. Even more worryingly, he doesn’t seem to care. There was nothing major in this budget to boost investment, and far from simplifying the tax system the Chancellor announced a raft of new levies that will make it even more complicated and wasteful.

Mr Osborne seems so firmly focused on the politics of the budget that he seems to have ignored the economics of it altogether.

– Sam Bowman, Executive Director

 Mr Osborne sounded a lot like Gordon Brown today

 Nigel Lawson's budgets were models of clear-sighted vision.  In every budget he cut taxes, simplified them, and abolished at least one altogether.  A George Osborne budget seems more like one of Gordon Brown's, a patchwork quilt of little measures with no clear pattern to it.

– Madsen Pirie, President

The Chancellor’s deficit plan is in tatters

Mr Osborne’s deficit reduction plans for this Parliament always seemed improbable but lowered growth forecasts make this plain to see. At the current rate of cuts, he will now need to find £31bn of cuts or tax rises in the year 2019 alone to deliver his surplus. This is highly unlikely and it seems almost certain that he will end up breaking all three of his own fiscal rules. In all likelihood he does not expect to be in the job by then and doesn’t mind handing the problem to someone else.

– Sam Bowman, Executive Director

Cutting business rates for small businesses is a bad idea – and could Italify British businesses

Business rates are mostly a tax on landowners, not on firms. Even though firms write the cheques, when business rates are cut, rents rise in proportion, so firms are no better off, but landowners are. Reducing rates for small businesses only makes this problem even worse. Not only will rents rise across the board for all firms, big and small, there now is a large distortion in favour of smaller firms present in the rates system, akin to rules in slow-growing Eurozone states like France and Italy. Smaller firms are generally less productive than large firms, and by creating a large distortion in favour of inefficient small businesses the Chancellor is risking the "Italification" of British business.

– Sam Bowman, Executive Director

Corporation tax cuts are modest good news

Corporation tax is—as George Osborne said—one of our least efficient taxes, destroying huge amounts of economic activity for each pound it raises in revenue. Cutting it from its current rate to 17% by the end of the parliament will put upwards pressure on productive investment and on workers wages, though the move is small. Devolving the tax to Northern Ireland is also very welcome—currently there is a very strong incentive for firms to site themselves just across the border in the Republic of Ireland, purely in order to pay lower corporation tax. Equal corporation tax on either sides of the border would bring the UK more revenue, and increase efficiency by reducing arbitrary distortions on where businesses should locate.

– Ben Southwood, Head of Research

The soft drinks tax is the thin end of the wedge 

A tax on sugary soft drinks is the first step on the road to fat taxes and sugar taxes more generally. It makes little sense to tax sugary drinks on their own, rather than sugar more generally – a couple of Mars bars are just as bad as a bottle of Coke – but the Chancellor probably reckons that the public won’t care if he only targets soft drinks. Once the tax is in place, he will follow the lead of other ‘sin taxes’ and raise it higher and higher, and impose it on more and more things. The costs of this tax will likely be passed on to consumers in the form of higher prices, so it will be regressive.

– Sam Bowman, Executive Director

Capital gains tax cuts are a return to normal

We should not exaggerate the chancellor's achievement with his capital gains tax cut, as he has only returned the main rate to the level enjoyed under New Labour, but it is nevertheless a step in the right direction. Reducing the returns to investment reduces investment, it's as simple as that, and most economists therefore oppose capital taxation. However, though the overall move is a step in the right direction, it also adds layers of complexity: lower rate taxpayers and entrepreneurs continue to pay lower rates, while housing and carried interest remains taxed at the old rate. Tax preferences for certain sorts of investment work against market signals, pushing cash towards areas it can do less good in.

– Ben Southwood, Head of Research

Raising the personal allowance is a good thing, but National Insurance thresholds have been left alone again

The Adam Smith Institute has campaigned for years to take the lowest-paid workers out of tax, and progress in raising the personal allowance is to be welcomed. But there has been no movement in National Insurance contributions, which are an income tax in all but name and kick in at much lower income levels than income tax now does – at just £8,060 per year. The Chancellor should target his income tax cuts on the poor and focus on raising National Insurance thresholds.

– Sam Bowman, Executive Director

The education changes will waste children's time and taxpayers' money

Announcing large, headline-grabbing education policy changes that were largely unrelated to funding in the budget would have been forgivable if there was evidence suggesting these moves would actually help much. But forcing kids to learn maths until 18, and stay in school until nearly 5pm, is going to cause lots of pain for little gain—Danish and Chinese evidence suggests that we'll see few if any benefits. Switching to an all-academy system, on the other hand, is probably a good move.

– Ben Southwood, Head of Research

Leveraging Up on Bank Stress (I): the Bank of England’s Leverage Ratio Stress Test

(For the previous posting in this series, see here.) This posting goes through the Bank of England’s stress tests of UK banks’ leverage ratios – roughly speaking, their ratios of capital to leverage exposure. The banks perform poorly according to this test even under the very low 3% pass standard used by the Bank. Moreover, almost all banks fail the test under the higher minimum standards called for under Basel III when it is fully phased-in – and even those pass standards are much lower than they should be. These results confirm that the UK banking system is in very poor shape.

In an earlier posting, I suggested that the leverage ratio – the ratio of bank capital to its leverage exposure – is a better capital adequacy metric than capital ratios that use a denominator expressed in terms of Risk-Weighted Assets (RWAs). This is because the leverage exposure is a more reasonable and much less gameable measure than the RWA measure.

In this posting, I will go through the Bank of England’s second stress test – the test based on the Tier 1 leverage ratio, i.e., the ratio of banks’ Tier 1 capital to their leverage exposures. The definitions of these terms were explained here.

In this test, the Bank sets its minimum pass standard equal to 3%: a bank passes the test if its Tier 1 leverage ratio post the stress scenario is at least 3%, and it fails the stress test otherwise.

The outcomes for this stress test are given in Chart 1:

Chart 1: Stress Test Outcomes Using the Tier 1 Leverage Ratio with a 3% Pass Standard

charts ab

Notes:

(a) The pass standard is the bare minimum requirement (3%), expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure.

(b) The outcome is the Tier 1 leverage ratio post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

By this test, the UK banking system looks to be in pretty poor shape. The average outcome across the banks is 3.5%, making for an average surplus of 0.5%. The best performing institution (Nationwide) has a surplus (i.e., outcome minus pass standard) of only 1.1%, four (Barclays, HSBC, Lloyds and Santander) have surpluses of less than one hundred basis points, and the remaining two don’t have any surpluses.

You should also keep in mind that this 3% pass standard is itself a very low one. Despite its pretensions to impose tough new capital standards, Basel III still allows banks to fund up to 97% of their leverage exposure by borrowing and to have as little as 3% equity to absorb losses. Thus, if a bank has a leverage ratio of 3%, then it only takes only a loss equal to 3% of that leverage exposure to wipe out all its equity capital and render it insolvent.

Basel III’s minimum capital requirement is also way below the capital standards maintained by non-financial corporates, which only rarely have capital ratios below 30%.

In any case, the Basel 3% minimum requirement would not have helped had it been in place before the financial crisis: by 2007, UK banks’ average capital to asset ratios had fallen to just under 4% - still above the Basel III minimum, but not enough to prevent the collapse of the UK banking system.[1] There is, therefore, no reason to expect that such a minimum capital ratio would protect the system in the face of a recurrence of the recent crisis.

Going back to our stress test, you have an easy exam with a very low pass standard, and yet the UK banking system barely scrapes through, if even that.

It is also curious that the two weakest banks hit the pass standard right on the nose: had the stress been even a smidgeon more severe, they would have failed the test. It is almost ‘as if’ the stress test had been deliberately engineered to ensure that the adverse scenario was as adverse as it could possibly be without actually pushing any bank over the edge.

To be clear: I am not suggesting that the good folks at the Bank would even dream of fixing their stress test to produce such an outcome. But I am saying is that it is quite a coincidence to get not just one but two banks whose post-stress outcomes just happen to come out to be exactly equal to the pass standard.

Be all this as it may, the Bank’s assessment was much more upbeat than any Jeremiad of mine. Regarding the five best-performing banks (i.e., the ones that actually got a surplus) it reported that the PRA Board had judged that the “stress test did not reveal capital inadequacies” for these banks and saw no need to mention that their surpluses were rather on the small side – 0.3% for Barclays, 0.4% for Santander, 0.7% for HSBC, 0.9% for Lloyds, and only 1.1% for the star of the class, the Nationwide.

As for the two dunces that got surpluses of exactly zero in the leverage ratio test, the PRA Board carefully noted that their capital positions remain above the threshold CET1 ratio of 4.5% and meet the leverage ratio of 3%”. Nice choice of words.

Despite their capital inadequacies, these two then got off with of a slap on the wrist from the PRA and their capital plans were approved.

The Bank’s overall assessment was then this:

The stress-test results suggested that the banking system was capitalised to support the real economy in a global stress scenario which adversely impacts the United Kingdom, such as that incorporated in the 2015 stress scenario.[2]

Personally, I would have slightly re-edited this statement to read as follows:

The stress-test results suggested that the banking system only just managed not to fail the test under the 2015 stress scenario and obviously we cannot draw any conclusions about whether the banking system would have passed the stress test under any other stress scenarios that we did not consider.

It might also have pointed out that the banking system would have failed the stress test if the stress scenario had been more adverse or if the hurdle had been even a little higher.

There is another problem as well. The 3% pass standard assumed in this test took no account of the additional leverage ratio requirements that will be phased-in under Basel III: these are the additional leverage ratio requirements corresponding to the Counter-Cyclical Capital Buffer and Globally Systemically Important Institutions Buffer. If we include these to their maximum possible extent under fully phased-in Basel III, then we get the outcomes shown in Chart 2:

Chart 2: Stress Test Outcomes Using the Tier 1 Leverage Ratio with the Potential Maximum Basel III Pass Standard

Charts ab2

Notes:

(a) Author’s calculations based on information provided by the Bank of England’s ‘The Financial Policy Committee’s review of the leverage ratio” (October 2014) based on the assumption that the pass standard is the potential maximum required minimum leverage ratios under fully-implemented Basel III.

(b) The outcome is expressed in terms of the Tier 1 leverage ratio - the ratio of Tier 1 capital to leverage exposure - post the stress scenario and post any resulting management actions. These data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

If the earlier outcomes reported in Chart 1 were bad, these are disastrous: the overall average shortfall is 0.85%,[3] only one bank (Nationwide) scrapes through the test with a surplus of under 0.1% and the other six banks fail.

It gets worse, too: it turns out that even these outcomes are still overly optimistic.

More on this in the next posting.

Footnotes:

[1] See P. Alessandri and A. G. Haldane, “Banking on the state,” November 6, 2009, chart 2, p. 24.

[2] Quotes from Bank of England, “Stress testing the UK banking system: 2015 results,” pp. 9-10.

[3] And if we applied those other adjustments too, then we would get an even higher average shortfall, i.e., 0.85% + 3.5% – 1.89% = 2.46%. Ouch!