FINANCIAL REGULATORS MUST TAKE CARE OVER CAPITAL / THE FINANCIAL TIMES COMMENTARY & ANALYISIS ( RECOMMENDED READING )

Financial regulators must take care over capital

By Jacques de Larosière

Published: October 15 2009 23:20

There is a growing consensus that financial institutions should be more adequately capitalised, that the pro-cyclical bias of the present combination of accounting and prudential rules should be reduced, and that liquidity should be strengthened.

But these are general objectives. They now have to be translated into appropriate reforms. In this respect two issues loom high on the agenda: how to design a safer system that would avoid the major weaknesses of the recent past; and how to make sure that the new measures are consistently implemented worldwide.

The first issue is of fundamental importance. Capital ratios, if they are not well conceived, could substantially harm our economies. I see a great danger here. Regulators must not start piling new ratios on the existing ones, adding further requirements (leverage ratios, special ratios on large systemically important institutions, anti-cyclical capital buffers) to the normal – and revamped – Basel 2 risk-based system.

Each of these new measures may have, individually, some rationale. But together, their impact could prove lethal. Changes in capital ratios have significant consequences for the banking sector’s propensity to lend and therefore for the financing of the real economy. History shows that economic recovery essentially depends on the existence of a strong and risk-taking financial system.

Thus, in designing and calibrating the new rules, regulators should take enough time to assess carefully their potential overall impact. In this respect, capital and liquidity requirements should be guided by an overarching principle: “The higher the risks, the higher the capital and liquidity requirements.” Imposing a non-risk-based leverage ratio could entail serious negative, albeit unintended, consequences. It is the quality of the assets of a bank that matters more than its leverage.

By the same token, the definition of a “systemically important institution” is far from simple. Size is certainly not the appropriate criterion. Medium-sized banks such as Northern Rock or IKB were not considered systemically important. But they created havoc. What is important is the business model of a bank, its funding mismatch, its risk profile, its governance and its interconnectedness.

All this calls for careful analysis and precise impact assessments. Let us not forget that the measures that will be decided will have a disproportionate impact on Europe. Bank intermediation finances two-thirds of the European economy; the share is only one-third in the US, where capital markets are more developed. Additionally, banks in Europe do not have access to the mortgage refinancing facilities provided in the US by publicly supported institutions.

Therefore, if we want a global level playing field and a consistent implementation of prudential rules, we need to take into account these kinds of specificities. A system that would impose across-the-board capital requirements adapted, for instance, to the risk profile of some large investment banks that played a major role in triggering the crisis, could penalise a number of European banks whose business and risk models are more resilient. A system of ratios that would be to some extent disconnected from effective risks would do nothing to address the causes of this crisis. It could only discourage financial intermediation and favour the use of non-banking innovative vehicles.

The task ahead is daunting. We must learn the lessons of misguided accounting and regulatory practices. We cannot afford mistakes that could endanger the future of our economies.

Another crucial but less publicised subject transcends the issue of additional capital ratios: it concerns the resolution regime to be set up internationally for cross-border banks. The US is building far-reaching solutions to achieve this goal. It is high time that Europe came up with a set of proposals on how to proceed when (or before) an international bank gets into trouble.

Innovative ideas in this field are being aired by some officials and the financial industry. We now have to make convincing proposals on the relevant tools and methods to be used. Such an objective should be high on the agenda of the European Union. Indeed, agreeing on preventive approaches would go a long way towards reducing the moral hazard problem created by the recent huge and improvised rescue packages.

The writer is co-president of Eurofi

Copyright The Financial Times Limited 2009.