State regulation of bank capital has encouraged banks to game the system and contributed to the problems of the financial crash of 2008. In this new paper, Do we need regulation of bank capital? Some evidence from the UK, it is shown that banks held appropriate amounts of capital before the introduction of capital regulation through the Basel system.
Capital regulation for banks is relatively recent. History demonstrates that capital regulation is not necessary if banks are not underwritten by the state. During the early-mid nineteenth century, there were a number of banking crises. Banks responded by holding higher levels of capital.
An analysis of bank capital shows that banks adjusted their capital ratios according to the risks that they were taking and that they were well capitalised in comparison with the standards set by regulators under the Basel I and Basel II approaches in later years.
Indeed, when bank capital levels became very thin after the Second World War, banks were prevented by the Bank of England from raising more capital, despite their appeals to the Bank. It was the banks themselves that wanted higher capital levels and the regulator that refused.
During this long period of prudent management of the banking sector, there was no clear expectation that the state would have stepped in to save an insolvent bank in Britain.
If banks know that they will bear the costs of failure, a century of evidence suggests that they will behave in a conservative manner. Therefore, the focus of bank regulation should be on ensuring the orderly failure of banks. Banks would then be more sensitive to risk and have more of an incentive to adjust their capital ratios to an appropriate level. Regulatory capital ratios lead to more complexity and the gaming of the system.
Recommendation: The whole apparatus of bank capital regulation which has done so much to make the banking system more opaque should be abandoned. Attempts by the British government to require large banks to hold very high levels of capital are misguided. Instead, the principle, which should be at the heart of regulatory reform, is that banks should be wound up in an orderly way if they fail.
Commenting on the paper, Prof. Philip Booth, the Editorial Director at the Institute of Economic Affairs, said:
“We still need to learn the lessons of the last financial crash. Banking is inherently risky and from time-to-time banks will fail. Great swathes of complex capital regulation made banking riskier and less transparent.
“The insistence on ever-increasing regulation of UK banks is simply encouraging gaming of the system. The best way to ensure banks accurately assess risk is to create a system so banks can fail in an orderly fashion. The requirement of the UK government for banks to hold more capital is damaging the economy. It also suggests that the government does not believe its own rhetoric when it says that new regulations will enable failing banks to be wound up at no cost to the taxpayer.”
Notes to editors
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The full report, Do we need regulation of bank capital?: Some evidence from the UK, by Forrest Capie and Geoffrey Wood, can be downloaded from www.iea.org.uk .
The mission of the Institute of Economic Affairs is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems. The IEA is a registered educational charity and independent of all political parties.