November 17, 2010 1:51 am

A simple rule is needed to prevent future banking crises

From Prof Richard A. Werner.

Sir, Vikram Pandit (“We must rethink Basel, or growth will suffer”, November 11) criticises the Basel III regulatory proposals on the grounds that higher capital and liquidity requirements “could have a significant negative impact on the banking system, on consumers and on the economy”. He points out that the result of the Basel rules could well be that “overall risk in the financial system will rise. More capital will not solve ... these problems.” He also argues that “it is not even clear that these higher [capital] requirements will make the broader financial systems safer”. He is right on all these counts.

What Mr Pandit does not mention is the main reason Basel will not prevent the next banking crisis: capital adequacy requirements are altogether the wrong instrument to try to rein in banks. That is why we have had just as many, if not more, banking crises after Basel I than before.

The reason lies in a little-known fact that is now acknowledged by Martin Wolf (“The Fed is right to turn on the tap”, November 10): namely that banks are the creators of the money supply. As such, they also create the money that is used to purchase shares newly issued by banks to bolster their capital ratios. Requiring banks to raise more capital in the boom times will not stop the boom in the first place – it is created by increased bank credit, which can partly be used to fund the higher capital adequacy ratios.

A different approach is needed to prevent banking crises – endorsed by Adair Turner, chairman of the UK Financial Services Authority: limits on the creation of credit by banks, according to the use the money is put to. One simple rule would prevent banking crises: allow banks to create credit only if it is used for transactions that contribute to gross domestic product. Only such transactions generate the income streams that make them sustainable in the long run. Financial transactions are not part of GDP. Why should the public privilege of money creation be accessible for them? This simple rule will also render obsolete any need to impose a Tobin tax or further restrictions on bonuses or hedge funds. Without credit creation available for financial transactions, we could say goodbye to costly asset bubbles and banking crises.

Richard A. Werner,

Chair in International Banking,

School of Management,

University of Southampton, UK

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