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A smarter way to strengthen banks?

By Claes Bell ·
Monday, April 22, 2013
Posted: 12 pm ET

Right now there's a lot of debate about how best to protect the economy from bank failures and prevent the next financial crisis.

The current approach -- which combines increased oversight, authority for the Federal Deposit Insurance Corp. to take over and unwind "systematically important financial institutions" and bigger equity cushions for banks under Basel III -- has yet to be fully implemented. But that hasn't stopped some in Congress from proposing even bigger equity cushions for "too big to fail" banks or chopping them up altogether.

On the other side of the spectrum, Sen. Richard Shelby, the top Republican on the Senate Banking Committee, last week called for the implementation of Basel III to be suspended until further study on its impacts can be completed.

"Congress needs a detailed analysis of current and new capital rules to ensure that taxpayers are protected without unduly impeding bank lending or economic growth," Shelby said in a statement. "Only a comprehensive examination of the impact on financial institutions large and small will meet this need."

Both sides have a point. The financial crisis has exacted a terrible toll on millions of people worldwide, and putting in place a framework of regulations to prevent future crises, while politicians and regulators are still feeling motivated to do so, is incredibly important. However, suddenly increasing capital requirements and other regulatory burdens is undoubtedly having a chilling effect on the lending the global economy needs to recover.

A paper published last year by economists Dimitrios Tsomocos, Charles Goodhart, Anil Kashyap and Alexandros Vardoulakis seems to point to a solution that could solve both problems: A global regulatory scheme that dynamically adjusts controls, such as the amount of capital banks are required to have on hand, based on the state of the economy.

The way it would work is this: As housing values and other asset values rise toward bubble territory, regulators would gradually increase capital, margin and other requirements, says Tsomocos, a professor of financial economics at Oxford University.

Doing so would slow down lending and borrowing, but in the context of a global economy that's heating up, that would actually be a good thing, easing the severity of any eventual housing slumps and making banks less likely to default on their debts.

In effect, you'd be putting a damper on financial institutions' ability to increase their leverage, which was one of the biggest drivers behind the most recent financial crisis. It also would help to shorten or even prevent the kind of "zombie bank" period that we're living through at the moment, where banks are too busy recapitalizing to do the type of lending the economy needs to recover.

In contrast, Basel III's approach is  more static. It sets capital requirements and other controls at a permanently higher level going forward, with a limited countercyclical buffer of 2.5 percent of assets that would be activated at the discretion of each country's regulators. Such rigid standards have the side effect of forcing banks to increase their liquidity just after a huge financial crisis, which may be impeding the economic recovery, Tsomocos says.

"The thing that has not been recognized yet is the rate of the increase in liquidity requirements may create adverse procyclical shocks for credit crunches and credit contractions," he says. "The countercyclicality is very important, and also (is) the dynamic adjustment of the regulatory rules. We believe that this is critical."

Also, to work effectively, global regulations need to apply to both banks and what's called the shadow banking system, the network of investors who buy mortgage-backed securities from banks, and participate in short-term, asset-backed borrowing and lending known as the repo market.

"You cannot have only one regulatory tool," Tsomocos says. "The place of macroprudential regulation is not only to regulate banks, but also the shadow banking system in a way that reduces the possibility of amplifying the adverse consequences of adverse financial shocks."

While Basel III recognizes the need to regulate the global financial market in addition to keeping an eye on individual banks, it doesn't do enough to deal with the shadow banking system, Tsomocos says.

What do you think? Which is more important to you, preventing a future financial crisis or recovering from the one we just had? Can we do both?

Update: An earlier draft of this post failed to reflect the fact that the Basel III standards already contain a limited countercyclical buffer that would be activated at the discretion of each country's regulators.

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1 Comment
H. M. Bell
May 13, 2013 at 6:39 am

The instability in international banking will be difficult to deal with the incredible influence of the banking sector. Look at how the Brits are pushing towards a referendum to leave the EU based upon the perception of fiscal insolvency. It is human nature to blame systemic problems on others. How many economies in the world were affected by the US banking / financial collapse? But here in the US, such a broad spectrum solution, as well reasoned as it is, would be interpreted as the "one world order" dictating policy to US financial entities.