Britannia Radio

Central bankers strike back

Published: June 19 2009 19:05 | Last updated: June 19 2009 19:05

Talk of green shoots inevitably tempers the shock of last year’s financial crisis, when Wall Street’s finest were falling like nine-pins. But the need for thorough regulatory reform is still pressing. One concern stands out: the risk of the whole financial system breaking down, as it did last autumn. Controlling systemic risk is the most important goal of regulatory reform; all else is secondary.

Those who want to give central banks the power and responsibility to monitor systemic risks are right. They include the US Treasury, whose proposals this week seek to turn the Federal Reserve into a systemic super-regulator. Mervyn King, Bank of England governor, called for similar powers.

EDITOR’S CHOICE

Opinion: The three steps to financial reform - Jun-16

Regulators seek to limit fall-out from crises - Apr-02

Analysis: Bank regulation needs straightening out - Mar-30

Britain heads for EU rift over regulation - Mar-19

Martin Wolf: Why the Turner report is a watershed for finance - Mar-19

Obama backs UK on crisis co-ordination - Mar-03

These proposals are contested. They should not be; the alternatives are worse. Members of the US Congress want systemic risk to be supervised by a new council of regulatory agencies. But as Lawrence Summers, US national economic council director, has said, collective responsibility often leads to no responsibility. And no single agency is as well suited to secure overall financial stability as a central bank with its liquidity-creating power. That, not monetary policy, was the Fed’s original purpose.

The solution is not perfect: one may legitimately worry that a double mandate – monetary policy and financial stability – weakens the ability to fulfil either well. But these tasks could be complementary; excessive liquidity can inflate balance sheets as easily as prices.

Things are more complicated in the European Union, whose integrated financial markets are not matched by cross-border fiscal or regulatory authority (or monetary authority, outside the euro area). The best that can be hoped for is the adoption of Jacques de Larosière’s blueprint which calls for an EU-wide systemic risk council with binding arbitration power over disagreeing national regulators. Europe must not remain exposed to the failure of banks with balance sheets larger than their home country’s economies.

Banks too large to fail are indeed too large; but that is only one source of systemic risk. A system of many small parts is also vulnerable to collapse, as shown by the cascade of bank failures in the 1930s. Limiting the size of banks, as the Swiss central bank is considering, may not prevent a crisis.

It is more important to make it possible for even the largest ones to fail. A special resolution regime is a sine qua non. Mr King’s suggestion of requiring banks to draw up plans for an orderly wind-down is a good one. Banks must also pay for any systemic risk they pose – by their size, their connectedness or the nature of their business – through bigger capital ratios.

Reforms to rein in systemic risk must not now fall prey to politics. They must be enacted before the memory of last autumn fades.