Bank Regulation’s Capital Mistake

Encouraging banks to turn loans kept on their books into securities also helped reduce the overall level of caution in the extension of credit. Additionally, strategies to circumvent the Basel rules made banks more complex and difficult to manage and supervise.

Smarter capital requirements – better Basel rules – aren’t the answer. Rigid, top-down uniformity is essential in the specification of weights and measures and the issuance of currency and coin. Bank lending and regulation, by contrast, must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help). The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.

We can no longer afford to rely on old-fashioned examination for mega-banks loaded with mass-produced risks. And because stockholders or raiders can’t force streamlining, governments must require these banks to shed activities that no one can manage or regulate and stick to hands-on case-by-case lending. With huge profits and bonuses at stake, mega-banks won’t readily abandon their model-based businesses; but, unless that happens, placing most of our bets on top-down rules would be reckless folly.

Amar Bhidé is a professor at Tufts University's Fletcher School of Law and Diplomacy and author of A Call for Judgment.

Copyright: Project Syndicate, 2011.www.project-syndicate.org

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