The prudential cost of the financial crisis

"Borrowers have been warned they face higher mortgage rates for up to nine years as banks hit customers with the cost of tighter regulation."

So begins the lead article in the Money section of this week's Sunday Times. The problem, it seems, is that the regulator has ordered them to increase their capital ratios.

So it's the regulator's fault, is it? Nothing to do with the imprudent lending in the lead up to the crisis? Prudence has been restored, not because the banks realise they made mistakes, but because they have been ordered to be more prudent. The guilty party is the one ordering prudence. And the cost is the cost of regulation, not the cost of good banking practice. Anyway, don't worry, because prudence will last only as long (nine years) as necessary.

And what happened to reserve requirements? Banks are in the business of borrowing money from some people (savers) and lending it to others (borrowers). The system cannot work efficiently if they have to rely on their own cash to lend (unless banks own most of the economy, they won't have enough of their own cash to meet demand from borrowers). But that is what the drive to increase capital ratios is trying (partially) to achieve.

There are two options to improve our financial stability. They are not mutually-exclusive, but they do have very different implications. Banks could improve their reserve ratios and/or they could improve their capital ratios.

  1. To improve their reserve ratios, they would have to offer higher savings rates to match the higher borrowing rates, until the two balanced. The gap between the two rates should not expand significantly - they would rise in parallel.The prudent (savers) benefit. Borrowers pay. Banks' margins remain similar, but volumes fall (because of the cost of borrowing) and therefore so do banks' profits (and bonuses).
  2. To improve their capital ratios, they have to increase the gap between saving and borrowing rates, to increase their margins on their activities. Savings rates fall as borrowing rates rise. Banks' clients of both types (saver and borrower, prudent and imprudent) suffer, though savers suffer more and borrowers suffer less than if greater emphasis were placed on increased reserve requirements. The banks (and their bondholders, shareholders and employee bonuses) gain.

Clearly, after our debt binge, we need to increase our savings rates to restore some degree of equilibrium. But we are pursuing option 2 almost exclusively. Rates for borrowers go up, for savers go down, and banks pull in the difference.

The argument of the intelligentsia, amongst whom this is widely agreed to be the right approach, is that to increase reserve requirements now would take money out of the economy at a time that it can least afford it. But increasing capital ratios takes money out of the economy too, and from both groups (savers and borrowers), rather than just from the people who need to tighten their belts (borrowers). This is actually the time that we can least afford not to do it.

Of course it will be painful, as borrowing gets even more expensive and less available, more businesses go to the wall, jobs are lost, and the economy shrinks. But these changes have to happen anyway. There is no avoiding a return to a more sensible equilibrium between borrowing and saving. The question is whether we let it happen, take the pain and then start again more sustainably, or whether we try to prevent the inevitable, ameliorating the immediate pain but prolonging its duration and extending the damage. And whether the ones who should suffer most pain (which is coming one way or the other) should be those who were less, or those who were more prudent.

The latter is the solution of America of the Great Depression and New Deal and Japan of the Lost Decade. Contrary to the journalists and economists who state blindly that "the recovery began in 1932", it didn't, and it won't work this time either. If somehow our governments and central banks manage to reinflate the economy (e.g. by printing money) without correcting this balance, they will only be preparing the ground for an even bigger crash later.

At some point, we have to accept that there is a natural balance in these things, that the interest rate reflects and corrects the changes in this balance, and that centralized direction cannot overcome this basic law. The impositions of regulators only reflect our attitudes and responses to this law. They do not create the costs, they just influence who incurs them and when, and thereby the lessons that people take from economic developments. Are we teaching the right lessons at the moment?