Wednesday, March 18, 2009

Lord Turner, chair of the Financial Services Authority (FSA), has today published his review of bank regulation. He was asked to produce this review by the Chancellor of the Exchequer in the wake of the banking crisis.

He recommends that banks should be required to hold more of their assets in the form of reserves, building up these reserves during prosperous times, so that they are not engaging in excessive lending that can result in cash flow problems. The recent policy has been to allow banks to make their own judgements about their levels of reserves - and many, seduced by the returns that are available from more profitable investments, have been caught out by allowing their reserves to fall too low. So this proposal is really about protecting banks from themselves. The proposal goes much further than stipulating a reserve assets ratio, as it drills down into the detail of banks' balance sheets.

Lord Turner raises the possibility that, to promote cautious lending, limits (dependent on the borrower's income) should be placed on the amounts that can be offered as mortgage loans. He also recommends that banks should be required to publish data on the risks that they are undertaking when making investments. It is difficult to see how this can be operationalised other than through a reliance on credit ratings - which are themselves now largely discredited and in need of reform. The Turner report proposes such reforms.

The report also states that, while the FSA has, in the past, taken the view that the market is right and that decisions made by banks in response to market forces are good decisions, it will in future question that view; in so doing it will become a more challenging regulator for the banks to work with. This has to be a good thing.

The report addresses also the bonus culture that has existed in financial institutions, and makes a sound recommendation that payment of bonuses should be deferred in order to ensure that workers' behaviour serves the long term interests of the bank.

Throughout the report, the emphasis is on securing international agreement and adherence to the reforms wherever possible.

But the key to the success of all of the above proposals is the quality of information that banks are required to provide. Auditing of this information will need to be robust, with severe penalties for misrepresentation. We have learned a lot about the power of hidden information over the last couple of years, and we have learned about how easily information can be concealed from view. Now we need to learn about how to flush it out. Lord Turner's report is a very welcome step in the right direction.
The International Monetary Fund (IMF) has revised downwards its growth forecasts for the UK economy over the next couple of years, and now expects overall negative growth in 2010 as well as 2009. While there is certainly a possibility of deflation and prolonged recession, my judgement would be that this remains a possibility rather than a likelihood. In particular, the introduction of quantitative easing should make falling prices less likely. The IMF forecasts therefore look pessimistic. It is perhaps worth noting that the IMF will not publish these forecasts until the end of April, as part of their World Economic Outlook series. Much can change between now and then.
Unemployment in the UK has risen above 2 million as the recession continues to bite. News on this front will get worse, probably much worse, before it starts to get better. Recessions tend to be fairly short lived affairs, and so growth should resume within the next year or so. But it takes more than a little growth to stem the rise in unemployment. Owing to the impact of technological change on productivity, the growth rate of real output in the UK needs to be about 2.5% per year in order to keep unemployment from rising. So we can expect the unemployment rate to rise for quite a while yet. Indeed, while the typical duration of a recession as measured by the period over which GDP growth is negative is about 18 months, it is typically the case that the unemployment rate rises for a further 2 or 3 years after the recession ends.

Tuesday, March 17, 2009

A new debate has opened about university tuition fees in the UK. A survey of vice chancellors indicates that most are in favour of a substantial rise in the upper limit on tuition fees, currently set at £3145 per year for UK domiciled undergraduates.

This might appear to be quite a simple question of striking a balance between public and private contributions to the cost of higher education. The reality is somewhat more subtle. Current practice is for the government to bundle student loans together and sells the debt to private sector investors - this debt is sold at a discount in order to reflect the fact that not all of the amount owed by students will be repaid. For example, if a graduate has any debt outstanding 25 years after graduating, then that debt is written off. As things stand, the discount is not huge, but raising tuition fees would inevitably lead to an increase in the debt that is not repaid - and hence would require the government to sell this debt off at a more substantial discount.

Put simply, raising tuition fees would raise the government's own commitment to spend on higher education. Removing the cap on tuition fees altogether would require the government to sign a blank cheque.

There are several potential fixes to this dilemma, none of them very pleasant. The rate of repayment of the loan could be raised above the current level (which is 9% of all income above a disregard). The interest rate subsidy on loans could be reduced or scrapped altogether. Loans to cover tuition fees could be limited to (say) £3145, and students would have to fund the gap between this and actual tuition fees - perhaps by taking out commercial bank loans or by way of parental donations. Another alternative would be to convert the current system into a fully fledged graduate tax, whereby graduates pay a higher rate of income tax than other workers, with no upper limit on the amount of repayment of the cost of higher education.

It is inevitable that universities, nervous about their prospects for continued government funding once the economic crisis is over, should wish to explore other avenues. The problem is that any attempt to shift more of the costs onto graduates would have to be very cleverly engineered in order to avoid imposing substantially greater costs also on the taxpayer.

Thursday, March 05, 2009

The Bank of England has once again cut its interest rate, this time to 0.5%. Significantly, the cut has been accompanied by an announcement that the Bank will engage in quantitative easing (QE) in order to render less likely the chances of inflation turning negative later this year. Such deflation would be extremely harmful to the prospects of economic recovery, since demand would collapse as people postpone nonessential purchases in order to take advantage of falling prices.

QE is likely, initially at least, to operate via the Bank's usual mechanisms - the new money will be released into the economy as the Bank purchases bonds and other securities from the commercial banks. The commercial banks would then hold more of their assets in the form of money, which they would then be able to lend to businesses or prospective house purchasers and consumers.

On 22 April, the budget will be announced. By then, it may become clear that QE could be used in order to finance a fiscal expansion. This, so long as it is concentrated on 'shovel-ready', quick win projects is also desirable under the present circumstances.

Some other recent announcements also give cause to think that we are now moving in the right direction. Yesterday it was announced that BT would invest £1.5 billion in fibre optic cabling. The company had been holding back on this investment in the fear that regulation would prevent it from reaping the rewards of its investment. But the regulator, Ofcom, has now guaranteed that there will be no regulatory intervention for superfast broadband, thereby clearing the way for this substantial private sector investment project to be kick-started.

Another recent announcement guarantees the future of Private Finance Initiative (PFI) projects that had been put under threat because of difficulties faced by private sector firms in securing funding from the financial institutions. The government is prepared to make direct loans in these circumstances. This is a vitally important decision because many such projects are already underway, and offer some of the most 'shovel-ready' opportunities for investment.

In this context, it is perhaps surprising to see that the opportunity for a significant capital investment in the further education sector has been pushed back. Hopefully this missed opportunity can be recovered at the time of the budget.