Loading Banks With Equity Essential for Healthy System
The Economist argues for incremental changes to the financial system rather than a complete overhaul, in a leader accompanying a new Special Report on the financial crisis.
Excerpts:
“Some argue that only draconian re-regulation can spare taxpayers from the next crisis. The structure must be changed … Yet this search for a big, structural answer runs into two problems. One is that the reform is not as neat as it first appears. Nobody wants to have banks that are so big that they stifle competition (itself a source of stability), but breaking big banks up into tiny bits that pose no systemic risk would be a horribly complex and lengthy task.”
“The second drawback is inefficiency. Limiting banks’ size could stop them from attaining the scale and scope to finance global business.”
Instead, it is better to focus on two more fiddly things that could produce fairly radical results: regulation and capital.
“Regulators should focus on function: if an outfit behaves like a bank, it should be regulated as one, whatever it says on the brass plate. Ideally each jurisdiction will incorporate a set of broad global principles, which establish a benchmark of prudent finance.”
“Regulators can also use markets. Banks’ solvency depends on a bedrock of capital. Regulators could monitor how this trades, or use markets that gauge the risk of insolvency, to help decide when banks must raise more capital. Regulators could get managers to watch for systemic risks by linking their bonuses to the bank’s bonds … Incentives matter: with higher risk charges on banks’ trading books, bankers would become more discerning about how they put their money to work, and less prone to make dangerous bets in pursuit of huge bonuses.”
“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers.”
“Hence the overwhelming importance of capital. Banks should be forced to fund themselves with a lot more equity and other risk capital—possibly using bonds that automatically convert to equity when trouble strikes. Higher capital requirements would put more of the shareholders’ money at risk and, crucially, enable banks to absorb more losses in bad times. Think of it as a margin for regulatory error.”
“Regulation cannot prevent financial crises altogether, but it can minimise the devastation. Loading banks with equity slows the creation of credit, but the reward for a healthy financial system is faster growth over the long term. There are three trillion reasons to think that the trade-off is worth it.”
The full Special Report includes articles on the following topics and can be downloaded as a pdf (fee for non-subscribers):
- Rebuilding the banks
- Banks and society
- Canada’s banks
- Bank balance-sheets
- The future of securitisation
- Gaining from the crisis
- Banking and risk
- Swedish lessons for banks
- The future of banking
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