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Home > Blogs > Anthony Harrington > Bank regulation: Firing at the wrong target?

Bank regulation: Firing at the wrong target?

Finance Blogger: Anthony Harrington Anthony Harrington

Few would expect the City of London Corporation to be hugely enthused about the current trend around the world for enacting tough new regulations against banks. So it is no surprise to find a report commissioned by the City of London setting out to do a demolition job on the Basel Committee’s revamp of Basel II. What is perhaps surprising is just how solid and persuasive the arguments made by the report actually are.

For a start, the report produced by European Economics [PDF, 401 KB] suggests that Basel III is shooting at the wrong target. It is trying to prevent bank failure per se, but the idea that drives capitalism is not that no firm should fail. Risk is part of capitalism and if you misprice risk badly enough, you go bust. That’s the nature of the game. What is actually needed is a regulator that is smart enough to call a wayward institution that is getting itself into trouble through mispricing risk, back into line. And if the organisation can’t put itself right, then the regulator needs an orderly way of winding up that institution without either collapsing the wider market or running foul of the anti-competitive practices and anti-trust authorities.

“In our view the fundamental ambition of prudential regulation of the banking sector cannot be that such restrictions are placed upon banks — such high capital ratios; such extensive liquidity standards; such close risk-taking restriction — that no bank will ever fail. Companies going bust is not capitalism failing; it is capitalism working,” the report argues.

In common with a number of the better commentators on the financial meltdown, European Economics argues that pushing up the scale of the capital buffers banks are supposed to hold fundamentally mistakes the nature of the crash. It did not happen because banks were holding too little capital. The credit freeze happened because banks wouldn’t lend to each other. Banks borrow from each other all the time. No one, in that sense, has enough capital. What killed the market was that banks couldn’t see where all the toxic assets were being held. The bank they were about to lend to might be dead on its feet, they just couldn’t tell. Others thought the same of them.

Counterparty risk went through the ceiling and so lending just died. That is a liquidity crisis, not a capital crisis. You don’t solve a liquidity crisis by adding more capital to the mix, because no one wants to lend to anyone anyway. You solve a liquidity crisis by removing the cause of all the fear that is going around, which means cleaning up the toxic debt mess. Once you’ve cleaned it up (and it is by no means all out the system, as the current furore over sovereign debt shows), then going around forcing banks to stockpile huge amounts of additional capital is not really to the point. All that does is to kill lending to business and damage the prospects for growth and recovery.

There is, of course, a very good argument to be made that organisations like Lehman were massively overleveraged. The scale of the bets they were taking versus their ability to cope with losses, was completely out of whack. Part of Basel III is all about containing or restraining leverage. But then, this is simply what any sensible regulator who was not asleep at the wheel, should have been doing anyway. Once again, it seems, we are back at the point where analysis shows us that what went wrong was that the rules that were in place to regulate banks were simply not used. What is needed is not more rules, but a better use of existing rules by a more alert regulator.

Further reading on Basel III and bank regulation

Tags: banking , Basel III , EU , financial crisis , Lehman Brothers , regulation , transparency
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