Banking is a lot safer than it was

The financial crisis was fought at the weekends. In sweat-stained shirts, fuelled by stale coffee and cold pizza, harried officials worked the phones and held emergency meetings with other bankers to discuss whether to save this bank or to let that one sink—all before markets opened on Monday. The Sunday scrambling reflected the fact that officials had too many fires to put out and too few good options to choose from.

Before the crisis, regulators hoped that the discipline of markets would ensure banks were sensible in the risks they took. That proved to be a vain hope, in part because markets are prone to exuberance and in part because many banks had become so large that they could not be allowed to fail and they knew it. The emphasis now is on drawing up a new rule book for finance. In America, the world’s biggest financial market, the Dodd-Frank act is reversing decades of deregulation. In Britain officials are pondering plans for banks to erect firewalls between the different parts of their businesses. All banks will be required to hold a lot more capital to protect them against unexpected losses. New rules on funding and liquidity will force them to keep more liquid assets that can be easily sold should they need to raise funds urgently. These measures are making banking safer than it was. But the job is still far from complete.

To make banking safer, regulators need to marry two seemingly contradictory aims. The first is to make it less likely that banks will fail in the next crisis. The second is to make it less painful for taxpayers when they do fail. On the first, the biggest gains come from raising liquidity and capital standards—and here there has been plenty of progress. The new Basel 3 rules will have the effect of doubling the amount of core equity that a typical big bank holds as a proportion of its assets. The standards come into full force only in 2019 but the market is making banks plump up their capital cushions far sooner. Had Basel 3 been in force before the crisis most big banks would have been sufficiently stocked up on capital.

Most, but not all. Only a handful of big firms, out of a couple of hundred worldwide, suffered net losses that the new Basel standards would have been unable to deal with. Forcing all banks to hold enough equity to ensure that even the worst outliers think Irish banks are safe is an option from the ivory tower. The amounts needed would harm banks’ capacity to lend, fail to discriminate between well-run outfits and badly run ones, and encourage risks to migrate out of the regulated banks to the shadow-banking system (another area that still needs lots of work). Regulation, even in a business as dangerous as banking, should be restrained and targeted.

A little layer cake in Basel

A bit more equity is sensible for banks that are interconnected and large enough to cause serious economic damage if they collapse. The simplest way of doing this would be to insist on a chunky capital surcharge for systemically important banks. The Basel committee should look at the debate under way in Britain, where an independent commission has proposed an additional equity buffer of 3% for big retail banks.

The other thing that regulators need to do is soften the blow when banks do get into trouble. Most countries are putting in place resolution regimes that allow regulators to shut down smaller banks. But letting a big retail bank close its doors completely is still unthinkable. The real task is finding a way to impose losses on banks’ owners and creditors rather than making calls on taxpayers.

Tools are being developed in the form of convertible-capital instruments and bail-in debt, whereby creditors of struggling banks are turned into shareholders if losses rise high enough. Swiss regulators, for example, want their biggest banks to hold the equivalent of 9% of their risk-weighted assets in convertible capital. The advantage of these instruments is that losses fall where they ought, on those who funded the banks, and that they provide a ready-made pool of capital that is cheaper than equity and large enough to recapitalise all but the most extreme failures. Questions swirl around these new instruments. Is there enough demand for them? Will they stop the problem of creditors running for the hills at the first sign of trouble? But a thick buffer of equity and convertible debt is the best way to make crisis-filled weekends less terrifying.