Joseph and the amazing technicalities

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: Bankers have a bad habit of making economic cycles worse. They are notorious for lending people umbrellas when the sun is shining and asking for them back when rain starts to fall. When the economy is strong and asset prices are rising, banks are only too eager to lend to those wanting to buy assets, helping to push prices higher. In bad times, when prices are falling, banks ask for their loans back, forcing the borrowers to sell assets and driving prices down further.

Right now, banks are desperately plastering over the cracks in their balance sheets created by the credit crunch. Last week Royal Bank of Scotland launched a £12 billion ($24 billion) rights issue. Other banks have tapped the bulging wallets of sovereign wealth funds. But there may be a limit to investors’ largesse: those who have bailed out banks so far have lost money.

If the well of investors’ patience does run dry and banks are forced to shrink their lending, the economic situation may get a lot worse. Already the riskiest borrowers in America and Britain are being shut out of mortgage markets, with predictable consequences for house prices.

Regulators are partly to blame. When the credit boom was roaring in 2005 and 2006, central banks did make pointed comments about the “underpricing of risk”—in plain English, that banks were not charging borrowers enough. But they did nothing about it; indeed, by keeping nominal interest rates low, they encouraged the credit excesses.

International regulations on the capital adequacy of banks do exist, but they tend to be procyclical too, requiring lenders to raise more capital only when the problems have already occurred. And the regulators tend to be one step behind the practitioners. Banks were able to exploit the first lot of so-called Basel rules, because they could hide risky loans off their balance sheets. The new rules, Basel 2, may be more sophisticated in their treatment of risk but they rely heavily on models developed by banks themselves. As the past year’s events have demonstrated, those models can be seriously flawed.

Cycling backwards