Bank capital debate obscures more urgent reform

March 17, 2011

By Peter Thal Larsen
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — Before the crisis, financial regulators were often accused of being in thrall to bankers. Today, they are in greater danger of being captured by academics. British boffins have recently got bogged down debating whether banks should hold significantly higher levels of equity. Even if the idea is right, it is not remotely realistic. Policymakers should concentrate on more modest but practical reforms.

The latest debate was started by David Miles, a finance professor and member of the Bank of England’s interest rate-setting committee. Miles applied the Miller-Modigliani theory of capital structure to banks, and concluded that the economy would be better served if they held capital equivalent to 16 percent to 19 percent of their risk-weighted assets. Basel bank regulators have agreed a 7 percent ratio.

Miles’s theory has been endorsed by both Mervyn King, the BoE’s governor, as well as Adair Turner, chairman of the UK’s Financial Services Authority. But in practical terms, it is a non-starter. For many banks, complying with the latest Basel edicts is already a stretch. If their ratios were whacked up to the levels that Miles proposes, equity investors would go on strike. That would force banks to raise capital from governments, or rapidly shrink their balance sheets, triggering another credit crunch. Turner acknowledges this, arguing that today’s regulators have inherited “a half-century long policy error” which cannot be quickly reversed.

The debate risks overshadowing a more modest, but more pressing reform: making big, systemic banks hold an extra capital buffer. The G20 group of leading nations has approved the plan, and Basel recently agreed how it would work. But Germany and France are resisting; the United States appears to be wavering.

Some countries have decided to move ahead. Switzerland plans to hold its two largest banks to higher capital standards, while Ireland, Spain and Sweden have introduced higher ratios across the board. Britain’s Independent Commission on Banking may take a similar approach when it reports in April. But in the absence of a global agreement, banks will try to arbitrage the rules. Policymakers should concentrate on securing a global deal, and leave the theoretical debate to the academics.

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What these guys need to worry about is the size of the banks.Regulatory oversight can only go so far. Capital requirements will have to be monitored.Alan Greenspan showed us that we cannot trust “regulators.” The only way to assure that we do not have a repeat of these sordid events is to do as Simon Johnson keeps saying—break up the banks!

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