Hamstringing banks with higher capital requirements will not stop the next crisis

Patrick Minford
GREAT fallacies periodically grip the British establishment and cause enormous harm to the economy. The last big one was the obsession with joining the European Exchange Rate Mechanism at the end of the 1980s. Now we have the regulative fallacy. The great and the good are in its grip.

They identified banks and excessive debt as the cause of the crisis, and resolved to prevent future crises with regulation. The result is that the cost of credit to those who rely exclusively on it (housebuyers with little cash and small businesses) has become prohibitive. And the price of this credit has remained immune to massive printing of money via quantitative easing (now an octupling of the monetary base). No credit growth has resulted. A recovery, which would normally have been invigorated by these groups, has remained weak.

The chancellor has tried to stimulate lending with the Funding for Lending Scheme (FLS), subsidies for mortgages, and a bigger version of FLS. But regulation has blocked the credit channel, and these palliatives will not unblock it. We need a new settlement with the banks, restoring their confidence and persuading them that they have regained their traditional ally: the Bank of England.

There needs to be new competition, aided by breaking up the bank monoliths in government ownership. And the emphasis for regulation should be on procedures for bank liquidation and recapitalisation along the lines of the US Federal Deposit Insurance Corporation, rather than externally imposed capital requirements. The Bank should supervise the banks, using its information strength. It should not “direct” them.

We must remember that the purpose of banks in the wider economy is to purvey credit to firms and households that would not be done directly by savers. By intermediating between savers and high-risk borrowers, banks bring down the private rate of interest. If the system works well due to competition, it drives the rate down to the risk-free rate plus a competitive margin, reflecting bank costs plus non-diversifiable risk. At the level of the whole economy, individual risks are cancelled out; the aggregate of investment made by competing individual firms, small and large, benefits the economy by its extra product.

Traditionally, the system has worked by eliminating the “credit friction” that pushes up the “credit premium”. But it is now said we should put obstacles in the way of lending to prevent crises. Regulation has imposed higher capital requirements on banks, related to their risk-taking. The effect has been to raise the credit premium on individually risky lending. Capital requirements add a further marginal cost, that of raising risk capital to maintain the capital ratio.

Yet how will this prevent future crises? Are crises produced by excessive lending, or are they caused by general shifts in circumstances which in turn bring down banks? The evidence points to the latter. Work in Cardiff has shown that US and euro-area crises are mainly caused by non-banking shocks, while banking shocks contribute a small further element. Studies finding a larger role for banking shocks attribute too big an effect to financial transmission, compared with what the data supports, and abstract from the permanent shocks that have caused the sharp downward shifts in activity we have seen in this Great Recession. This is in line with conclusions in a recent Brookings study, which finds that, in the US, the shocks causing the crisis are no different from the shocks that have caused previous post-war recessions. They are just bigger.

In other words, hamstringing banks will not stop the next crisis, but will damage the economy to make some small dent in the economy’s fluctuations. This is a poor trade-off; it would be less costly to moderate these fluctuations with an effective monetary policy.

Rather than interfere in the internal structure of banks, authorities could ensure that the structure is competitive and that free entry is maintained. The Basel agreements, which aim to regulate risk-taking by banks by setting capital and liquidity requirements, have become onerous and raise the credit premium. It is time to pull back from the current approach to one that is more modest, which recognises capitalism will encounter crises from time to time, but which will likely prove more effective. This approach would respect the limited knowledge which in general exists, respect the industry’s own knowledge, and also respect that of the industry’s leader, the Bank of England.

Monetary policy can be expanded to account for the unobserved elements in the credit premium by additionally targeting the money supply; this would better perform the control of excessive credit booms. The knowledge base on which it draws should be augmented by the Monetary Policy Committee becoming a free-standing government committee, serviced by both the Treasury and the Bank. Competition should be the main aim of official intervention, and the Bank should supervise a self-regulating industry. The government must be ready to restore the whole system when it is rocked by events. We must again let markets work in our banking system.

Patrick Minford is professor of applied economics at Cardiff Business School. This is an extract from The Financial Sector and the UK Economy: The Danger of Over-Regulation, published by Politeia. www.politeia.co.uk