What we really need is to reintroduce capitalism into banks

Allister Heath
REGULATORS are a bit like retired generals, always refighting the last war. It will take another economic catastrophe before we find out for sure whether the global banking reforms, agreed at Basel yesterday, are truly fit for purpose. I’m not optimistic – no centrally planned, crude attempt at making a complex system safer ever works – but many of the new rules will be beneficial, and the regulators’ decision not to squeeze the availability of credit even further is to be welcome.

Banks pre-crisis didn’t hold enough capital buffers to protect themselves against losses; many of the assets they did hold were of poor quality. Banks were merely following the global rules, as codified by previous Basel accords; but these were grossly inadequate, full of loopholes and incentivised bad behaviour.

Whenever regulators get involved, statutory minimum standards become maximum standards. If you must hold a certain amount of capital, at great expense, and this level is officially deemed to be safe, then why hold even more? The result is inevitably a race to the bottom. But it was actually even worse than that. Engineering the Financial Crisis by Jeffrey Friedman and Wladimir Kraus, one of the few genuinely good books on the Great Recession, describes how the original Basel Accords actually encouraged banks to stock up on dodgy, mortgage-backed securities. Perverse incentives at the heart of the system of bank capital-adequacy regulations were paradoxically one of the key drivers of the incorrect decisions taken.

Add that to moral hazard and the knowledge that central bankers stood ready to step in at the first hint of trouble and one got a toxic mix. Market discipline – with shareholders, bondholders, depositors and counter-parties all incentivised to keep risk under control – was replaced by regulatory indiscipline.

The new Basel III rules are a vast improvement. Some perverse incentives have been eradicated (though plenty of outcomes that many won’t like remain – it will be prohibitively expensive for banks to lend to small firms, as these are much more likely to default than large ones). They are also more sensible in some respects than the original draft. Allowing some corporate bonds and even some mortgage bonds – albeit with big haircuts – to qualify as liquid assets makes sense. There is no such thing as a truly safe and liquid asset – government IOUs fluctuate in value as their yields change, and states often go bust or inflate themselves out of trouble. Forcing banks to hold only government bonds could have caused the next crisis (even with the relaxed rules, this may still happen).

The new rule on minimum holdings of easily sellable assets will be phased in until 2019. This is a good thing. The reforms of the past few years have been counter-cyclical: by forcing banks to hold more capital and liquid assets at the height of a recession, when ordinarily they would have been able to do the opposite, has helped to intensify the crisis. The cost of credit needed to go up – but more gradually.

Ultimately, however, what is really required is to reintroduce the fear of failure into the banking system, and to banish bail-outs and subsidies. Basel seeks to reduce the likelihood of failure; but what we really need are new tools to manage failures when they do happen. The game-changing reforms will be about reintroducing genuine capitalism into banking. The G7 and others are working on new bankruptcy and resolution mechanisms for large banks – they must become a reality in 2013.

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