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: Banks and free lunches traditionally go together. Lenders are run for private benefit, but taxpayers underwrite them if things go wrong. Yet the scale of support that has been extended in the current financial crisis is unprecedented: the entire system has been explicitly guaranteed. Even as unemployment soars, bankers are talking again of big bonuses and a “war for talent”. The woeful legacy of the crisis could be a supersized banking system gorging on the taxpayers’ tab.
Regulators want to prevent this, and their tool of choice now seems to be tighter capital-adequacy rules. This week Britain announced reforms that put a strong emphasis on capital, and other countries are expected to do the same in the coming months. Even though banks have often found their way round such rules in the past, this approach probably makes sense for two reasons.
First, it reflects the lack of alternatives. Governments have turned away from the really radical options for reform because there is no easy way to resolve society’s desire for cheap and efficiently delivered credit with its wish for stability. Breaking up the biggest banks might not make them safer, and politicians seem not to have the stomach for the fight it would entail. Taking the banks into public ownership, to be micromanaged by politicians, has obvious drawbacks too.
Second, capital, the buffer between banks’ assets and liabilities, is indeed at the heart of the problem. The bigger that buffer is, the safer a bank is likely to be. Low levels of capital ordinarily frighten off creditors but state guarantees give depositors and others every reason to keep financing the banks. If governments cannot retire these guarantees—and doing so is not credible given the crisis—they have to mandate higher capital.
What should capital rules try to achieve? First, they can expand the system’s buffer to a level which protects taxpayers from losses. The existing Basel 2 rules proved to be too lenient. Regulators now have a better idea of how much capital is needed to survive a meltdown. Heading into the crisis, America’s banks would have needed at least double the present minimum core-capital ratio of 4% to have avoided raising equity or breaching that floor at the bottom of the cycle. The broad outcome is clear: as the economy picks up, capital must be built up substantially from the low it is likely to hit in 2010. The rules must be...
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