Basel II means a further tightening of the credit crunch

The news today that London Scottish Bank is being told by the FSA that it needs to raise additional capital is a grim reminder that the credit crunch of 2007 gives 2008 a grisly hangover. London Scottish itself is a small company, led by a new cautious CEO who wants to provide for difficult conditions in the lending markets and to meet the Regulator’s requirements for capital. Understandably he wishes to write off anything he has inherited which he does not like the look of, just to be sure. The provisions can always be put back at a later date into profits if conditions improve. The importance of this small case is that it setting a standard for how much write off and provision should be made against certain types of lending. The Regulators will use it as an example of how much capital a bank now needs in these straightened times. It could mean more write offs and more capital raising by the bigger banks.

There is always a danger that worldwide regulators will seek the lock the stable door after the horse called Prudence has well and truly bolted. If they do this on any scale, they are tackling last year’s problem of excess, not this year’s problem of too little lending and confidence which will delineate the opening months of 2008. Regulators will reason that they must learn the lessons of the period of too much credit, and now demand more cautious lending as well as insisting on banks having bigger reserves and more spare capital. This impulse will intensify the downturn in lending and keep money tight in banking markets. Inspired Regulators respond to the conditions that pertain today, looking ahead to tomorrow’s problems. Other Regulators look back to past problems and try to make sure they can never happen again. They will, of course, once the Regulators have been forced to respond to the next set of problems which are the opposite of those of the period of excess.

All this has been made much more difficult for the western economy by today’s adoption of Basel II, the new regulatory capital requirements. The natural temptation for the world’s regulators will be to use these new rules as an opportunity to revisit the money banks need, and to raise the standards, demanding more liquidity and more capital for any given volume of business. If this had been done a year or two ago it would have been a very good thing, and would have reduced the excess in lending and leverage which characterised the easy money era. Done too much today, and it will deepen the crisis, reducing the amount of money available for lending in the system still further, and pushing banks into more aggressive competition to raise the regulatory capital they need to sustain their current level of business.

Regulators are very important players in this credit crunch. As I argued yesterday, the regulatory requirement for Home Information packs is distorting the UK housing market, keeping homes off the market and delaying the price adjustment. Worldwide banking regulation could reinforce the boom bust lurch in credit markets if we are not careful. In the good times Central banks and other regulators turned a blind eye to the big build up of lending and the low levels of liquidity held by some institutions. Now they might go too far the other way, demanding standards of prudence that the damaged and constrained markets will struggle to provide at sensible levels of new lending.

All this is relatively bad news for the UK economy, where government indebtedness and the huge balance of payments deficit add to the unfortunate inheritance for 2008. There is talk of further tax rises to tackle the excessive government borrowing. There should instead be talk of controlling public spending better, as the last thing the UK economy needs right now is a set of further stealth tax increases. The government could begin by showing it now understands the need to control its spending, by getting a grip on how much it will lend to Northern Rock and when it intends to receive some repayments. It could cancel the hated ID cards spending, on a day when it is revealed that the UK has come to rank in the lowest grade of countries with respect to protecting citizens’ privacy. The Privacy International Think Tank just tells us based on comparative study what many of us have known intuitively for some time – we have lost a lot of liberty, and the government is sending us the bill for all the suurveillance and form filling. There will be an economic price to pay for all this in 2008 as well as the loss of liberty.

1 Comment

  1. mikestallard
    January 2, 2008

    The FSA looks, from the outside, to be another thoughtless EU imposition. Is this so?
    The government, in all its forms, is, as you so rightly point out, the last organisation that ought to be controlling the Bank of England. It is far too slow, for one thing. As you also say, "political experts" are now fighting last year's scenario. Also, "experts" work in generalities, not specifics.
    What I am afraid of is that someone reliable, like Harriet Harman, will be made Governor of the Bank of England when the currrent Governor "retires".

    Reply: I don't think the FSA as such is a requirement of EU law, but clearly it is a requirement of EU law now that we have a a UK financial regulator or regulators who implement all the massive EU legislation on financial services.

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