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As both a journalist and a believer in capitalism I find the tidal wave of new regulations washing over the banking sector repugnant. For a journalist, thousands of pages of new rules make for dull reading. For the capitalist in me, they demonstrate a fundamentally flawed approach to the allocation of capital in the economy.

The problem the regulators are trying to solve is well known. Big banks are too big to fail, so intertwined with other financial institutions that when their bets go bad they cannot collapse without pulling the global financial system down with them.

Unfortunately, politicians refuse to address the problem head-on. The US and Europe are unwilling to break up big banks. While a special commission in the UK is considering such a move, the institutions’ response is to threaten they will move elsewhere rather than split up.

Governments have opted instead to treat banks like small children. We have new rules, new smacking rights for the regulators and new capital requirements – think of these as Pampers to absorb the leaks from financial institutions. Goldman Sachs has even been put on the naughty step by the US Securities and Exchange Commission.

This extra red tape is not just destined to fail. It actually reinforces the position of the banking oligopolies that dominate most major economies, thus reducing competition.

Start with the capital, the most controversial and complicated part of the new rulebook. The Basel Committee on Banking Supervision’s third effort to get banks to hold appropriate capital is undoubtedly tougher than previous attempts. More capital does mean banks will be able to absorb bigger losses before failing, and reduces their profitability. It is a cost on the business, which should make them safer – all else being equal.

Unfortunately, all else is not equal. As Andy Haldane, executive director for financial stability at the Bank of England, points out, banks create their own risk. Since the costs of failure fall on the taxpayer, institutions have a huge incentive to create “tail” risks that, although rare, are potentially disastrous.

Mr Haldane put it bluntly in a speech earlier this year: “Because tail risk is created, not endowed, calibrating a capital ratio for all seasons is likely to be, quite literally, pointless – whatever today’s optimal regulatory point, risk incentives mean that tomorrow’s is sure to be different.”

More adult supervision is not likely to work, either. New financial stability regulators have been created on either side of the Atlantic, following the dismal failure of existing watchdogs to spot the bubble in credit. How likely are they to succeed, though? Spotting bubbles is notoriously difficult; the “it’s different this time” crowd always includes the rich and powerful, and politicians like to rub up against the new wealth that bubbles create.

There is also the chance that the new financial stability specialists may be more successful than the snoozing regulators of the past decade, until you remember that most of them are the snoozing regulators of the past decade, just in a new job.

None of this is to say that the system is heading for implosion, nor that regulation should be abolished. In spite of manifest failings over the past 10 years, regulators can prevent many problems.

But they need help. We need to force the bond and money markets to supervise the banks. Before you conclude that this is the insane rantings of a free-market fundamentalist, consider the cause of the financial crisis.

It was not about fat cat bankers, collateralised debt obligations, sub-prime mortgages or any of the other favoured targets. These were simply the symptoms of a bigger problem: the subsidised cost of capital to which banks had access. The result of the implied government guarantee that follows from being too big to fail was that banks were able to borrow money far too cheaply. Because banks are the core of the capital allocation system, this distorted the entire global economy.

Rather than being limited by governments, banks should instead be restricted by their cost of capital. Currently, bondholders, repo counterparties, commercial paper buyers and other institutions provide banks with the money they need to function, and charge for the risk of not getting it back. However, they are all but assured that they will, since none of the big banks can possibly be allowed to fail. So moral hazard has taken over.

If banks had to pay their full cost of capital, they would be much less likely to make such costly mistakes in the first place. Further, if they did, then the cost would fall on those taking the risks, rather than the taxpayers.

To be fair, governments think they have an answer to the moral hazard problem: “living wills”. These are plans for failure that, combined with new bankruptcy regimes, are designed to ensure even the biggest banks can be broken up and sold off in an emergency.

Unfortunately, they are also unlikely to work. Either the radical simplification of bank structures needed to ensure that living wills functioned would require measures so similar to a break-up of the big banks that they would be politically unacceptable, or living wills would be useless when a large, complex bank did actually fail.

The reaction of both investors and credit rating agencies shows that what has been done so far is not enough. The subsidies that distorted global capitalism remain. Governments have wasted two years without addressing the real problem. It is time for them to stop nannying banks and let them compete – and fail – in the world outside the playground.

The writer is the FT’s investment editor

Copyright The Financial Times Limited 2017. All rights reserved.
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