De Larosiere on Bank Regulation

On a first reading, there is an elephant in Jacques de Larosiere’s kitchen. The report recommends a new architecture for pan-European supervision, falling short of a single pan-European regulator as Kevin O’Rourke notes. It also recommends revisions to Basel II, without much in the way of specifics. The report has been welcomed by the Commission and is to be considered by EU Finance ministers next month.

The elephant is moral hazard. European governments have instituted wide-ranging guarantees of bank liabilities, amounting to de facto (and potentially free in some cases) unfunded deposit insurance for commercial banks. The report rattles on about the possibility of a limited and pre-funded deposit insurance scheme, with the option of national variations on a European template. But it seems to me that the genie is out of the bottle, and that, if and when business-as-usual returns, the public will not believe that there are deposit insurance limits. If there is a systemic crisis, Governments will be expected to step in. Even if there is just one distressed commercial bank, it is difficult to see how the clamour for retrospective liability guarantees can be resisted. These expectations could be with us for generations.

Clearly there are categories of near-banks (hedgies, prop-trading units) which could credibly (in the eyes of the public) be placed outside the pale, and denied guarantee. But how to prevent banks, believed to be guaranteed, from lending to these entities at inadequate rates, endowed with too-cheap funds from the public deposited on the basis of an assumed guarantee?

The net question is this. What are the implications for regulation and supervision of a European banking system in which liabilities of all the main commercial banks are perceived to be guaranteed?  Can it be less than Glass/Steagel, plus high capital and liquidity ratios, plus intensive supervision and risk monitoring beyond anything thus far contemplated?

Margaret Thatcher lamented, at the end of the Cold War, that nuclear weapons could not be de-invented. Can the perception of perpetual availability of retrospective and ‘costless’ bank liability guarantees be de-invented?

4 replies on “De Larosiere on Bank Regulation”

Some thoughts:

1) Arnold Kling (blogging at proposed that misbehaving bankers face criminal sanctions (“I think that we ought to make it a crime to endanger a financial institution that has government backing”

2) It is said that the banks are “too big to fail” (or better “too big to be permitted to fail”). Although talk of merging our banks has died down lately it is still a likely outcome of their troubles. This combination makes it more likely there will be banking misbehaviour in the future.

3) From the bogus non-resident accounts scandal we know that Irish banks and their staff (and many of their customers!) are not too bothered by technicalities like the criminal law. Perhaps what matters most is not what the regulations or sanctions should be, but rather that punishment be guaranteed (that word again)..

4) One of the causes of the current problems is that risk has proved very difficult to measure. So monitoring it will not be easy..

5) People like Charles Goodhart have pointed to the pro-cyclicality of Basel II and proposed changes/alternatives (see–23627967.pdf).

It might be best to have an implicit guarantee (that is, usually rescue banks when they fail including full restitution of deposits) but limit the bad side-effects of this implicit guarantee via tighter and more strictly enforced risk capital requirements and other risk-control regulation on banks. In essence the moral hazard problem can be dealt with by enforcing a legal ban on the offending behaviour rather than by using the threat of bank failure to remove the temptation to misbehave.

Isn’t the “moral hazard” question something of a red herring. Surely the reason we got into this mess is because the banks all the time operated under the assumption that they were too important to be let fall. Therefore the moral hazard is not being introduced since it is always there. So if we accept that there will always be moral hazard because of an unofficial insurance, surely the obvious thing is to institute an official government insurance, such as our deposit guarantee, and ensure that proper market rates are paid.

Colm, the shadow banking system (called this not because its dodgy but because it followed banking like a shadow) failed in many ways, on one hand they relied on banks and became leveraged too high, then when they couldn’t continue financing operations [they borrowed short and invested long] much of the assets landed back on the banks balance sheet and the buck was well and truly passed. The real issue is that such institutions should have leverage limitations built in the same way that banks have fractional reserve limits. And of course you can’t cover everybody so they would have to hang (although history doesn’t demonstrate that with the likes of LTCM etc.)

and lastly, if there is a systemic crisis, Governments will be expected to step in… this has always been the case. the real corner we must turn is that of ensuring maximum pain for all involved if they state are called for safety, that is the maxim of central banks to begin with… lender of last resort, lend freely at high margins on good collateral.

just because we have sinned for the last decade doesn’t mean the commandments are wrong.

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