Why New Bank Capital Rules Could Make Things Worse

John Carney

Investors will likely breathe a sigh of relief when international regulators reach an agreement on bank capital requirements this weekend.

Early reports suggest the required levels of capital will be much lower than feared, and the kinds of assets that can be used to meet the requirements more expansive than earlier proposals suggested.

But there is good reason to worry that far from making the financial system sounder, Basel III may introduce even more systemic risk into global finance.

The problem is inherent and probably unavoidable. Regulators want to achieve a world-wide harmony on bank capital rules. But by reducing the diversity of regulatory regimes, they inevitably increase the costs of regulatory error.

Regulations homogenize. Banks told that certain assets count as regulatory capital will hold more of those assets than they otherwise would. If those assets are less safe than the regulators believe, banks will be more vulnerable and the banking system more fragile than it would be with less homogeneity.

As Jeffrey Friedman has pointed out, it was prior capital requirements that encouraged banks to hold large inventories of mortgaged-backed securities. The financial crisis was a result of what happened when the bursting of the housing bubble met this regulatory-created concentration.

“Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators’ errors,” Friedman explains. “But this is what all regulations do.”

We’re sure the regulators in Basel are well-meaning and striving to implement prudent and informed rules. The problem is that the future is unpredictable. What’s more, any set of regulations that seeks to cover something as complex as the global banking system inevitably will have unintended consequences. Further, even well-wrought regulations cannot easily adapt to changing circumstances.

Markets can cope with uncertainty because they do not require homogeneity. Different companies make different predictions about which businesses will be profitable. The ones that get their predictions wrong lose money; the ones that get them right earn profits. Persistent or outsized predictive failures led to bankruptcy; while persistent or outsized predictive successes leads to growth or at least continued operations. The market process sorts winners from losers without anyone having to determine who made the right predictions.

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