As a critic of the regulators in 2006-7 I said the banks should be made to hold more capital. In those days they were too heavily geared. The banks were allowed to lend far too much money with far too little capital to pay the losses if some of the loans went wrong.
The Regulators said the world had developed a new paradigm. Long words often conceal sloppy thinking. The world of banking, they argued, had become so much better at managing risks. Because the banks were bigger and global in many cases, they could take on much more risk. Subsequently they discovered that more risks meant more problems. All the risks could go wrong together. Spreading risk did not necessarily equal reducing or managing risk.
Now the Regulators argue the opposite. They believe that banks needs huge quantities of capital to back up loans, as they think many loans can go wrong. They add to the confusion by regarding loans to governments as risk free, at a time when they are about to learn the hard way that loans to government also carry substantial risks. The regulators have regulated the commercial banks into too much sovereign debt risk at the wrong time, whilst discouraging private sector risk at a time when we need more loans to power recovery.
Making banks hold more capital does two things. It lowers their profitability, and it means they lend less. That would have been a great thing to do in 2006-7 when things were getting out of hand. It is an odd thing to do when the banks need to rebuild their balance sheets and when good risks go unfinanced in the economy.
Regulators now say they need to hold more capital to pay the losses that are all too likely on the loans. It is true that banks may still have to pay for large losses on loans made in the heady days of 2006-7. The fear for the nationalised Irish banks is that they may lose many billions more on property values that have been badly hit by the crash.
What we need from here is patient and better management of the bad generation of loans made prior to the Credit Crunch, allied to more loans for businesses and properties now, in the post crash enivronment. By definition values are now a lot lower and the risks on future loans therefore diminished.
Banks need to be profitable to get out of this mess. Economies need to grow to get out of this mess. If the alleged remedy for the ill is just more capital it will restrict or stifle growth. That in turn means less profits and fewer loans, which in turn makes it more difficult for the banks to be nursed back to health.
The Regulators thought they had created a perpetual motion prosperity machine when they turned a blind eye to excessive lending and asset price inflation before the crash. Bankers loved the freedom the Regulators gave them to write more loans and book more bonuses. They need to be careful they now do not create a perpetual motion misery machine which keeps asset values low or falling, which prevents enough new loans and business, and makes it impossible for the banks and the economies to trade themselves out of the mire.
The recent decision to increase banking capital in Ireland by E24 billion, taking it to a total of E70 billion and the effective nationalisation of the major banks, shows how expensive this policy and past mistakes can prove. These are huge sums for a small country. All this debt is a burden on Irish people for many years to come.
Meanwhile it is important that the UK does not make any contribution to future Euro area bail outs. The policy is questionable as an approach anyway. It is quite wrong for the Uk to make loans to a system it rightly stayed out of. Lending money to countries which cannot grow owing to a high exchange rate, high taxes and spending cuts is not a great idea.