Credit Crunch-the Regulators are also to blame. Boom and bust central banking.

The Central banks concerted action is a move in the right direction, and better late than never. It is part action and part spin, as it is designed to rebuild confidence to get banks lending to each other.

The reason they will not is that they are all worried about meeting their regulatory requirements.

It was the capital requirements placed on banks by regulators that led so many of them to bundle mortgages and other loans up into special vehicles and funds, and spread them around the market. Under the regulators’ rules this enabled banks to lend more with less capital. Encouraged by very low interest rates, they did this on a huge scale, with the regulators watching them and saying nothing. The regulators should have limited the amount of this lending by scoring it differently for capital purposes, or by demanding a more prudent valuation of the packages.

When interest rates were hiked by the Central Banks in the US, Europe and the UK, this started to undermine some of the loans made to individuals who struggled to pay. This in turn undermined the value of the packages of loans spread all round the banking system by regulatory requirement. This has now led banks to need to husband their own cash, limit their new lending and try to tidy up their own balance sheets, to offset the large losses they are having to report. No wonder they do not have money to lend to other banks. Now the regulatory system is doubling up the impact of the higher interest rates, and making banks sit on cash instead of lending it.The Regulators are effectively tightening after the damage has been done.

This is a massive disaster for the world’s regulatory system for banks, made far worse by the lurch of the Bank of England and the other main Central Banks from boom to bust in their approaches to interest rates and monetary management. The Fed has been more decisive in trying to correct for too much tightness. The Bank of England is still a long way behind the plot.

It is high time there was proper recognition of the crucial role played in this sorry story by the regulators. They designed a system which powered huge off balance sheet lending. They allowed it to be valued on a favourable basis with relaxed capital requirements on banks. Now they are doing the opposite, at the very time when they need to relax a bit to get banks able to lend to each other again to keep the system going.

There is at the moment a fashionable syllogism:

Regulation is there to prevent individual banks crashing and to prevent system failure

We have a tightly regulated system which has just witnessed 2 German banks and 1 UK bank get into trouble, and has witnessed a freezing of the markets

Therefore we need more regulation!

This is another area where we do not want more regulation. It is an area where we need governments to show some skill and some understanding of where they are in the credit cycle. At the moment we have boom and bust governments, allowing skewed regulatory requirements when money is too loose, and threatening too tight a regulation when money is too tight.That is the way to make a bad situation worse.

1 Comment

  1. David Muldowney
    December 13, 2007

    John, a wonderful explanation of the current market turbulence.

    Like all your blog contributions, the product of a clear and disciplined mind.
    Can I also thank you for the EU Treaty post which I fully endorse.
    In Ireland, we're getting a referendum (they can't get out of it constitutionally). It looks like it'll be the usual stitch-up, the official classes (media,parties etc) bringing us all to the right decision. And, as history has shown, we can always have another go if we get it wrong! The whole thing is incredibly depressing. I wonder when the worm will turn here, maybe when the attack the EU have begun on our business tax rate hits home.

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