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Governance Not Regulation

di - 14 Aprile 2009
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Capital Ratios
When a bank fails (using the term “fail” loosely for the moment) there is an immediate and adverse effect on its competitors. This comes through three channels. If the bank is large, there is turmoil in financial markets. To the extent that other banks had contracts with the failed bank, these contracts are at the least frozen. Even if most of the money eventually comes back, it may come back slowly. And third, confidence in banks generally is weakened, and this loss of confidence can lead to a “flight to quality” which in the last resort can become a flight to liquidity requiring central bank assistance.

Now, that of itself does not justify interest in them by government. But what does justify that interest is the important role of banks in the economy.

This has led, surprisingly recently in the case of some countries, to governments (or central banks) imposing regulations on how much capital banks should hold. This is currently set by the Basel committee of central banks and supervisors, so the current set of regulations are known as Basel II .

The fundamental difference between Basel II and its predecessor, Basel I, is that required capital ratios are related to risk in a much more complicated way. Thus, the more risky a bank’s portfolio (of assets) the higher is the capital required. This seems sensible. It is what prudent banks would do without prompting. This is no doubt exactly the viewpoint that led to such widespread support for the principle of Basel II. But supporting Basel II because it produces what prudent banks would choose to do involves a misconception.

First, assessing relative risks in a continually changing market, with rapid financial innovation, is not easy. Assessments are likely to be wrong, and to change frequently. Second, the attempt at greater accuracy inevitably involves greater complexity. Third, although there is reliance on banks’ internal risk assessments, Basel II actually suggests quite strongly how such assessments be made. This has two difficulties. First, we can certainly not be sure we know the right model; and second, it may encourage herding, all banks responding to the same stimulus in the same way.

And fourth, there is widespread agreement that Basel II will produce “pro-cyclicality” – increased bank lending in booms and reduced in slumps – since risks in general fall in booms and rise in slumps. The disagreement that exists over this issue is only over how big the effect will be.

Now, all these criticisms were generally accepted at least to some degree and after recent events have been proven fully justified. There is however a more fundamental point. Banks hold capital to use: they run it down as a result of negative shocks and build it up as a result of positive ones. In contrast, regulatory capital sets a floor below which capital is not allowed to fall. Regulatory capital is not for using.

Does this mean that banks should be left to choose their own capital, as they choose their usable capital?

They certainly were in the past; and some systems, notably the UK, proved singularly robust.[1] It is undoubtedly correct that regulators are concerned primarily about the above-discussed “external effects” of bank failures, while banks are concerned to survive to earn future profits. But despite this apparent difference of interest, (note that it is difference not conflict: both regulators and banks want banks to survive) in the past banks, it seems highly likely, took heed of both issues. One cannot of course infer this from the ratios they held (even if one can get the data). But one can infer it from actions banks took to monitor other banks, and to protect themselves from failures by others. See in evidence clearing houses, the famous Suffolk Banking System in the USA, and banknote return arrangements in Scotland under free banking. Why can we not rely on self interest now? The answer, it may be argued, is that the governance structure within banks has changed. In the periods just considered banks, although sometimes quite large, were smaller than now and, very important, in much more concentrated ownership. Further, those who managed the banks usually had a large amount of their wealth in the bank.

So why not reform “governance”? Why not require bank management to hold their wealth, in increasing proportions as they become more senior, in the Bank’s equity? This would start to produce the alliance of desired outcome with incentive that we saw in the past. This would not produce perfection, but it would surely improve behaviour.


1.  This was the case even before the mid 20th Century, by when UK banks were a well capitalised and well diversified cartel

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