By Avinash Persaud

The IMF received additional resources and the OECD finally got tough with European tax havens. But beneath the veil of global unity, different regional perspectives and national measures are emerging. In Europe, the emphasis is on introducing macro-prudential regulation such as counter-cyclical charges and minimum liquidity buffers. In the US, policy debates are occupied with concerns that private investors, not taxpayers, should hold “contingent capital” which carries implicit or explicit conversion into equity in a crash. On top of that, voices in the US call for greater use of centralized trading. These proposals are micro-prudential in nature.

In the former crisis countries of Asia, the view is more sanguine. Officials from Indonesia, Thailand, Malaysia, Philippines and Australia argue that since Asia largely escaped the financial crisis, the downturn must be about poor supervision in Western economies. Consequently, their view is that we should tinker less with regulation and instead increase supervisory capacity.

The principal point of convergence between these perspectives is that the crisis was caused by “the others” and “they” had better get their house in order. Another point of intersection concerns big banks and the common need to play to the political gallery: Taxes have to be raised, a desire that sits well with the idea that politics should offset the incentive for banks to become systemically ever more important. I have long argued this point, but I have also come to realize that the notion of avoiding systemic shocks by limiting the size of banks is partly based on an illusion.

Bank balance sheets bloated by leverage are systemically dangerous, and regulators should address this through liquidity buffers and leverage ratios. But given how contagious crises are, it is likely that what is too big to fail is actually small. Any 2006 list of institutions based solely on size would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns or even Lehman Brothers. While some banks are more illiquid than others, they are intrinsically illiquid institutions and it does not take a large failure to lead to panic. In a crisis, almost everyone is too big to fail. Regulators should rather aim to make the financial system less sensitive to errors in the markets’ estimate of risk.

We can experience a boom followed by a crash with the same economic misery in a world of small banks as in one with big players as history has shown: In the 1973-1975 Secondary Banking Crisis in the UK, 30 relatively small financial institutions had to be supported by the Bank of England in the wake of a property boom. That crisis rivals, and to some extent exceeds, the impact of the current financial crisis on the UK. In the 1970s, the fashionable argument of the day was that small, competitive financial institutions are inefficient and under invest in their own longevity by having less conservative lending practices. However, the systemic effect of having one large bank engaged in rapid lending growth is no different from having several small banks do so. It may even be easier to resolve a crisis with one large bank.

In the current post-crisis discussion, it is often argued that bankers’ underestimate of risk is encouraged by the conviction that if it all goes belly up, their institutions are too big to fail and therefore safe. If that were the case, they would not wrap themselves up in the equities of their institutions and the leveraged products they sell. But they did just that. Banks and bankers did not lend more because they relied on taxpayers bailing them out anyway but rather because they thought it was safe. They were more fools than knaves.

The main driver of excessive lending and leverage is a misperception of risks irrespective of the institution’s size. Major financial services companies such as J. P. Morgan and HSBC proved to be safe and did not seek or require state funding while those that failed were relatively small: IKB, Bear Sterns and others.

What we are looking for is regulation that makes the financial system less sensitive to errors in the markets’ estimate of risk. There are two ways to achieve this.

Booms have similar characteristics: strong growth in bank balance sheets and credit as well as a rise in leverage. As the appearance of these factors implies an increased probability of the market underestimating risk, regulators should raise minimum capital requirements when they spot these trends. A range of indicators would have to be used to calibrate the rise in the capital requirements. Market-efficiency zealots will complain that the market cannot make predictable mistakes, but there are various reasons why the market fails to correct its systemic errors, one of them being the often told story that “this time it is different.”

Financial systems can be further protected by limiting the flow of risks to institutions on the basis of structural instead of statistical risk holding capacities. In the past, risks of similar statistical magnitude flowed to whoever was prepared to pay for them. But the capacity for risk is related to the maturity of funding – an idea that resonates with the concept of Paul Volcker, chairman of US-President Barack Obama’s "Economic Recovery Advisory Board".

Although responses to the crisis are becoming increasingly national, current proposals to reform banking regulation carry some promise. This is especially the case with counter-cyclical measures discussed by the Basel Committee and the Volcker proposal. Yet however tempting it may be, we should be careful not to expect too much from bashing big banks.

Published by PROJECT M online in March 2010

(Photo: gallerystock/Christian Schmidt)

This article originally appeared on www.voxeu.org, the policy portal of the London based Centre for Economic Policy Research. It was edited for Project M online. Please note that the opinions expressed in this article do not necessarily reflect the views of the publisher or the Project M editorial team.