Tighter bank regulation won’t stop boom and bust, but it will damage growth and prosperity

10 years after the crisis began, voices are urging additional, even more stringent bank regulations (Source: Getty)

Most commentators blame the banks (or “the banksters”) for the global financial crisis of 2008 and the ensuing Great Recession.

According to a much-repeated script, in the years running up to the crisis, greedy banks took too much risk and held too little capital in their balance sheets. Further, falls in aggregate spending were caused by a lack of confidence that reflected fragilities in the financial system.

Bank failures, notably the Lehman Brothers collapse in September 2008, are seen – in this widely-held view – as precipitating an intensification of the downturn.

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Given this diagnosis, the seemingly logical policy reaction was to tighten bank regulation. From October 2008, the International Monetary Fund (IMF) and the Basel-based Bank for International Settlements (BIS), acting of the behest of the G20 group of leading nations, pressed for higher bank capital-to-asset ratios. A new so-called “Basel III Accord” of banking system rules was approved in 2010.

Today, 10 years after the crisis began, voices in both Europe and North America are urging additional, even more stringent bank regulations.

Far too many people believe that “better” regulation is the answer to financial crises. But further regulation involves an expansion of the power of the state, and a loss of freedom for the financial system.

Remember that Britain had no explicit official rules on bank capital until the 1980s, yet no British bank suffered a run on its deposits over the preceding century. Crucial to the success of British banking in the decades before the Northern Rock fiasco was the Bank of England’s willingness to lend to solvent banks if they were having difficulty funding their assets.

Good central banking helped Britain’s commercial banks to run their businesses efficiently and profitably, and to the benefit of their customers.

Compare that to the effect of the Basel III regulations.

Has the bank recapitalisation drive been such a good idea? The rush to enforce higher bank capital-to-asset ratios revealed an alarming lack of understanding – at the highest levels of international policymaking – of subjects vital to global prosperity.

Key officials at the IMF, the BIS and leading central banks did not see the links between banks’ capital regimes and the quantity of money, and then between the quantity of money and macroeconomic outcomes.

Increasing the ratio of bank capital to assets in the midst of a financial crisis had disastrous consequences.

Banks reacted to official demands by selling securities and cutting credit lines. The resulting shrinkage of risk assets meant a contraction in deposits on the other side of the balance sheet and, hence, a sharp fall in the rate of growth in the amount of money in circulation (broadly defined).

The subsequent crash in money growth worsened the slides in demand, output and employment, and was the main cause of the severity of Great Recession.

The years since 2011 have enjoyed greater stability in the growth of both money and nominal expenditure. We must in future ensure that this stability is maintained, and avoid further blunders in monetary policy and financial regulation.

The IIMR is holding two events next month, on 7 and 8 November, to discuss financial regulation, capital adequacy rules, and monetary policy as a whole. The 7 November event, with guest speaker Martin Taylor, is open to the public. You can find out more here.

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