Bigger, more interconnected banks have a disproportionately large influence on the health of the financial sector, the three Bank economists said, implying they should face regulations requiring disproportionately large capital ratios.
This would also have the benefit of discouraging the growth of banks to the point where they were “too big to fail”, the authors argue, since bigger, more systemically linked banks would be able to lend out less with the same stock of reserves.
Regulation should also take into account the business cycle in setting out capital requirements, another paper from the Bank released yesterday suggested.
Counter-cyclical reserve ratio regulations would discourage “gambles for reputation” that some bosses engage in good times, the authors of the second paper argued. These short-termist gambles often result in “socially inefficient credit booms which ultimately lead to bank losses,” the paper said.
High ratios in good times mean firms do not get carried away with irrational exuberance, but low ratios in bad times – when gambles are much less likely – can counteract firms’ equally excessive pessimism, it added.