David B Smith
There are two main reasons why granting the Bank of England the power to impose capital ratios may prove helpful – macroeconomic and prudential. The essential macroeconomic aim of monetary policy should be to maintain a smooth and steady growth of broad money. It’s difficult to do this with the traditional tools of monetary policy – the bank rate and gilt-edged funding. Furthermore, both tools are now exhausted, hence the need for an additional monetary tool to impose restrictions on commercial bank balance sheets. The prudential reason is that banks with inadequate capital resources go bust if they cannot cover the rise in bad debts that comes not only with recession, but also in the early stages of recovery when cash flows come under most pressure. There is an important caveat, however. The heavy-handed imposition of capital ratios will lead to a renewed downturn.
David B Smith is a visiting professor at Derby Business School.
Governments have a high opinion of their ability to steer and direct the economy as they would like. Unfortunately, this view ignores the hard realities. The main focus of prudential policy – on which there has been progress – should be to ensure that insolvent banks fail safely. We should not be binding the financial system up with so much regulation that banks never fail. Additionally, monetary policy should be conducted in such a way that generalised asset bubbles are not created in the first place. Furthermore, prescriptive, government-imposed accounting rules should not encourage banks to inflate profits when times are good. Beyond that, what evidence is there that government regulators can foresee bubbles and prevent them through regulation of the banking system? Governments would do best if they stuck to the doctrine of “first, do no harm”.
Philip Booth is programme director at the Institute of Economic Affairs and professor of risk management at Cass Business School.
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