Too much new bank regulation makes getting over the credit crunch more difficult.

Governments are changing their position over banking regulation. When the credit crunch first struck, they were cautious and said there was no point in seeking to bolt the stable door after the horse had gone. As banks were now trying to recover from a weak position and were risk averse there was no need to strengthen controls over risk taking.

As the credit crunch has carried on its weary way there is a growing impatience as regulators feel they ought to be saying something as a prelude to doing something. We are now in to “This must never happen again” territory, allied to a view that there must be seen to be a toughening of regulation after the problems of sub prime and beyond.

There is the usual regulatory syllogism. Banking is a well regulated industry. Banking has just got into a mess. Therefore we need more regulation.

It does not flow. The truth is that the detailed regulation of banking under Basel 1 encouraged banks to put risks off balance sheet and to securitise. It was their enthusiasm for doing this that led to the well publicised problems at certain institutions. Left to their own devices to assess capital adequacy, they might not have gone so far in those directions – the regulatory sums allowed them more leeway and gave a sense of false security. No self respecting banker would be seen to have substantially more capital than the regulator thought was necessary. Northern Rock was discussing how to reduce its capital surplus under current rules before the run began.

There are currently three preferred options on offer for re-regulation of the banks. Each one has a role to play when we are coming out of the credit crunch, but each one if imposed too strictly and too soon could make getting out of the crunch more difficult.

1. More transparency. Usually more transparency, more published information about the state of a company, is a good thing. It acts as discipline on the company, and allows others to assess how much business to do with that company. However, when there are fears about bank weaknesses, a sudden rush to publish more may fuel the fears rather than reassure. Different banks will have taken a different line on how to value assets, how to assess liabilities, and how much capital cover they need. Changing the numbers or flooding out new numbers at or near the low point of the cycle could damage.

2. Mark to market. Some say the way to ensure clarity and comparability over banking numbers is to require all banks to mark the values of their assets and liabilities to market. That means that if they hold bonds, shares and bonds in securitised vehicles, packages of mortgages or the like, these should have a market value and that should be used in declaring the bank’s position. Again, this is a good idea in normal times, but in these conditions it could lead to a rush to the bottom. If bank A has to mark its holdings down a lot by marking to the new lower market prices, then it may have to start selling some of the assets to buttress its position. This could drive the market price down further, leading to more weakening in its balance sheet position. If the bank intends to hold the assets until maturity or for a reasonable length of time, making them mark them to market now could be disruptive. They need to be examined in private on a case by case basis where they wish to deviate from marking to market, if necessary in conjunction with the regulator to see fair play. There is no necessity to value a bond or mortgage at a low market price if the bank can and will hold it to maturity and get full repayment.

3. Require more regulatory capital to allow for the risks of a future credit crunch and difficulty in raising money market funds. Again this would be a prudent decision, but at the moment when banks are working hard to ensure proper balance sheet rations and liquidity for current tough conditions, an added requirement would be far from helpful and would delay recovery.

Stephen Lewis (Insinger de Beaufort)has recently written a good piece examining the IMF’s claim to be the obvious choice for a new world super regulator role over the banks. He shows how the IMF in the run up to the recent credit crunch was reporting that systemic risk was low, and was not warning people that we were about to enter the worst conditions in money markets for at least 35 years. He too is concerned, as an experienced analyst of money markets and a City expert, that overdoing the extra regulation at this point could impede recovery. This is becoming a serious and long running credit crunch. The work of the authorities around the world should concentrate on rebuilding confidence and liquidity. That should not include subsidising banks or taking on unreasonable risks from the banking sector, and it should certainly not include nationalising banks. It should include taking action to make markets more liquid and buying assets from banks at prices that mean the taxpayer does not lose.

The originate and distribute model, where banks arrange loans and mrotgages and then sell on packages of these loans to others, was a way designed to reduce the risk to the banks, and a method to allow them to extend more credit. As Mr Lewis argues, this was not such a bad idea when done sensibly. It would be a pity if such practises were made impossible in future, as it could limit credit growth more than is desiarable.


  1. Acorn
    April 15, 2008

    I think we have an example of the rush to regulate with the impact of IFRS rules to pension funds. The result was a mass exit from final salary company pension products.

    I will not mention unfunded public sector pension fund deficits today.

  2. Mark Wadsworth
    April 15, 2008

    Banking supervision is far simpler than that. I recently stumbled across a BoE publication from 1997, in which the authors conclude "…concern could still arise over individual institutions … who pursue a strategy of aggressive wholesale funded expansion".

    A bit like Northern Rock, whose share of net mortgage lending (per the bank's own accounts) of 8.4% and total assets of £57 bn in in mid-2004 had miraculously increased to 18.9% and £119 bn by mid-2007. I won't bore you with stat's on the extent to which it depended on wholesale funding.

    So anybody who didn't see this one coming was wilfully negligent, AFAIAC.

  3. tim holden
    April 15, 2008

    Banks are never popular. In the current situation an attempt will be made to make them a scapegoat. This will be done by a man seeking to regain popularity, and he has a regulation-mad government somewhere behind him that hopes he will be able to restore lost good faith.

    Regulation won't get the money back, and will worsen the price of housing. And the government has recently become a banker. The clunking feet trampled on something smelly in the park, and now they're going to spread it all over the carpet.

    The new spindoctors at Number 10 are going to find out just how difficult the new job really is….

  4. Adrian Peirson
    April 26, 2008

    Did you Know that the Federal Reserve is Neither Federal, nor does it have any reserves.

    I understand the Bank of England is the same, IE it is not Englands Bank, that Public money is Borrowed into existance from the Owner of the Bank of England.

    reply: The Bank of England is a company, with share capital owned by the government. Our whole system of finance depends on credit creation by the banking system, supported by a paper currency which has value all the time people have confidence in it.

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