What We Need to Keep the Economic Recovery Going

I'm in Davos this week for the World Economic Forum. It's encouraging that, after several years of discussing the crisis, this year's theme "The Reshaping of the World: Consequences for Society, Politics and Business" is now looking forward.

It's a thought-provoking topic. Here's the link to a guest article on "The 'Silent Austerity' in Banking" by UBS Chairman Axel Weber and myself from yesterday's Wall Street Journal. And a group of UBS’s Opinion Leaders, top research, economists have written a white paper on the theme of this year's Davos meeting, which argues that following the impact of "disruptive" technology on the media and consumer sectors, financial services could be the next major industry in the spotlight.

I hope you will find these both interesting reading.

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The 'Silent Austerity' in Banking

Private consumption is stuck in low gear in Europe and much of the industrialized world. This is a problem because our ability to return to growth depends on our ability to create both sustainable private consumption and sustainable public finances. There is a risk that recent shifts in regulatory initiatives may cause unintended consequences, further constraining growth.

Let’s start with some simple facts. Since the start of 2008, government consumption at the global level has risen by 20% in real terms, whereas private consumption has risen just 5%. In other words, despite talk of austerity, government spending continues to run ahead of private-sector spending. This has two important implications—one structural and one cyclical.

Structurally, government debt and the share of government spending within the economy must be sustainable. Last year, government consumption’s share of global GDP reached its highest level since 1980. At the same time, government debt-to-GDP ratios have hit record highs in many countries. The window of opportunity for mature economies to bring government debt levels down to sustainable levels is gradually narrowing due to demographic shifts and associated implications for growth rates.

Cyclically, private consumption needs to make a bigger contribution to the next phase of economic recovery. Private consumption is the largest component of global GDP, but its share was already falling at the start of the recession and continues to hit new multi-decade lows.

Several factors are at work, including a potentially self-reinforcing cycle of diminished business confidence, unemployment, and weak consumer spending. Fiscal restraint may also have played a role in weakening growth. However, equally and simultaneously, a form of “silent austerity” is to be found in the banking sector, arising from increased financial regulation, deleveraging and an associated restraint on private-sector credit supply.

How serious is this banking and austerity nexus? Initial impact studies have found it to be significant but not sizable. However, in recent years some tension has emerged between the competing objectives of regulators wanting banks to hold more capital, and the broader policy aim of lifting growth through increased credit and bank lending.

There are two ways banks can increase capital ratios: either by increasing capital or by reducing risk-weighted assets (RWAs). A recent paper by the European Banking Authority shows that the Core Tier 1 ratio for 64 EU banks rose to 11.7% in June 2013 from 10% in December 2011. This improvement has come fairly evenly from banks both increasing capital and reducing RWAs.

Within that reduction of risk-weighted assets, there has been an implicit incentive for banks to shift away from capital-intensive corporate lending to less capital-intensive activities, such as lending to governments.

Weak bank lending has been somewhat offset by capital-market activity. The problem is that bank lending still makes up 80% of corporates’ total funding mix. Moreover, although debt issuance is an option for large listed companies with reasonable credit ratings, it is not a viable form of financing for smaller companies—let alone individuals.

As a result, the improvement in banks’ capital positions conflicts with the increased focus towards availability of credit. U.K. Chancellor George Osborne recently expressed this dilemma as the need for “financial stability, but not the stability of the graveyard.” However, a perceived recent shift in emphasis toward leverage ratios and standardized risk models, at the expense of model-based capital ratios reflecting the actual risk characteristics of underlying portfolios, could lead to further deleveraging by banks. Ultimately, this would decrease banks’ lending capabilities and necessary private-sector investment.

The Basel III standard of regulatory capital requirements is a major step forward. While the focus is on the increase in risk-based capital ratios, the quality of capital has also increased massively and RWA calculations have become stricter and more comprehensive. We share the opinion of the Basel Committee that the leverage ratio should retain the character of a “backstop measure.” It should not become a binding capital constraint in the normal course of business.

However, the Basel Committee’s recent agreement on how to define the leverage ratio, while providing some necessary clarity, addressed many issues related to investment banking and not enough concerning the traditional banking business. This leaves questions about stimulating growth, particularly in light of calls by some for an increase in leverage-ratio requirements far above the internationally agreed level of 3%.

The Basel definition of the leverage ratio does not make a distinction between low-risk, high-quality liquid assets, such as cash or highly rated government bonds, and high-risk illiquid instruments. This is problematic as banks could be forced by market pressure to decrease liquidity buffers consisting of high-quality liquid assets to boost their leverage ratio and profitability. These banks would have less protection against liquidity risks, thus increasing instability—surely not the intended consequence.

Because the definition does not consider the relative riskiness of assets, nor accounting and regulatory differences, banks with identical leverage ratios can have completely different risk profiles. Yet this is not evident to investors or policymakers focusing on the leverage ratio alone. Ironically this favors banks that have not adapted their business models, and is fundamentally at odds with prudent risk management and safe and sound banking practices.

Importantly for private consumption, encouraging banks to hold riskier and less liquid assets can also limit the demand for lower-risk business that would be beneficial for overall economic prosperity, such as mortgages and trade finance.

At UBS, we are committed to the goal of improving the stability of the financial system. We caution against an overreliance on the leverage ratio and standardized risk models as regulatory tools—they would set the wrong incentives and could slow economic growth. We think that the fragile recovery can best be supported by focusing on the consistent implementation of the risk-based framework agreed under Basel III, rather than attempting to reform the reform before it’s actually been implemented.

Mr. Weber is the chairman and Mr. Ermotti the CEO of UBS, the world’s largest global wealth manager.

Read more coverage from LinkedIn Influencers in Davos here.