Difficulty of Bank Regulation

Amdist the furore over MPs expenses another issue to slip from the public eye is the near banking collapse of a few months ago.

Just to recap:

• Banks engaged in very risky forms of lending which ended up leading to large losses. The bad debts meant banks were short of finance and so interbank lending dried up.
• Risky bank lending fuelled asset price bubbles in many housing markets, But, the subsequent shortage of lending then hit the housing market and wider economy leading to the deepest recession since the 1930s.
• Amongst many mistakes, the Banks badly misjudged risk. Sub prime lending was often rebundled into prime lending and this hid the dangers inherent in the bank lending. Bank Executives / mortgage companies misled if not actively lied about the state of their finances.
  
• Unfortunately, many banks had reduced their liquidity ratio to increase profitability and relied on short term funding. When this short term funding dried up they either went bankrupt (like Lehman Brothers) or relied on massive government bailouts to pull them through.

Some will also say the regulators failed to prevent the banks engaging in irresponsible lending. But, if banks can't lend responsibly what is their purpose?

Since then not a huge amount has changed. At the moment, banks are constrained by economic circumstances and have voluntarily changed their lending criteria, but, when the crisis abates what is to stop a repeat of the previous few years?

Issues which need to be addressed:

• The culture of bonuses and reward for risky behaviour. In this post the problem of bank bonuses we saw how bank employees could gain from taking risky options without having to face the cost of losing risky decisions.
• Interesting Post - Crazy compensation and the Crisis at Wall Street Journal - which has more on the systemic risk that is encouraged by the set up of many investment funds
  
• Moderating Bank Lending in a boom. In a boom banks get carried away by rising house prices and start lending more. They may say they will be more careful next time. But, can we rely on banks to self-regulate?
• Inflation Target Insufficient. The lessons of the past decade is that for macro economic stability targeting inflation is wholly insufficient. Also using just one main variable - Central Bank base rates is also insufficient.

The challenge for macro economics is to:

• Understand fully the macro economic impact of bank lending, asset prices on economy.
• Develop policy for targeting these other issues like house prices and bank lending.
• Set up a workable framework for government owned banks. It is not just free market institutions which can make bad decisions. Governments are just as capable of misunderstanding and bad planning.

One thing which definitely should be borne in mind is the contrast between those financial institutions which remained non-profit making building societies and those building societies who became aggressive, increase market share banks. (Northern Rock, Bradford & Bingley, e.t.c)