The newest set of financial regulations arrived, courtesy the Basel-based Bank for International Settlements, at the start of this week—the very week Lehman Brothers Holdings Inc. fell two years ago. But this set, “Basel III”, hasn’t absorbed a philosophical point that Lehman’s fall sent reverberating through the world: To wit, the financial sector shouldn’t be given too much leeway, else it can get out of hand.
This sector got out of hand in the pre-Lehman years, growing to 8% of output in the US. Such a bloated sector only extracted rents (as Thomas Philippon at New York University shows) and was of little social use. It would be natural to presume, then, that policy since the meltdown would try to cut this sector down to size. On the contrary, policymakers have chosen to restore banks not just to health, but also back to pre-crisis size.
That’s one key reason Western central bankers have kept short-term interest rates near zero since late 2008. The banks that survived are having the time of their lives: They borrow cheaply at the short end of the yield curve and lend expensively at the longer end, these profits being the explicit intent of policymakers.
The run-up to the much-anticipated Basel III spawned a similar debate over how much leeway bankers should get. Force banks to reserve too much capital, and their profits could sink, hurting the rest of the economy; too little, and they will replay the crisis.
In the final analysis, the new norms mandate that banks should effectively set aside 7% of their assets as equity capital, instead of 2%. Is that tight enough? Harvard’s Samuel Hanson and Jeremy Stein, with Anil Kashyap, argue that banks should reserve at least 12% to survive bad times. Two Basel reports last month point out that raising capital ratios wouldn’t hurt the rest of the economy.
What is worse is that banks don’t need to implement these new requirements until 2019. A decade is a long time in global finance: Considering the last 10 years saw banks innovating to get around rules and take on more debt, they could easily innovate again to make Basel III pointless by 2019.
Regulators, under the impression that what is good for banks must be good for the rest of the economy, are letting them off the hook. That’s a tragic replay of the same philosophy that gave the world bloated banks and, eventually, Lehman.
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