We need a new approach to bank regulation – Mervyn King

We need a new approach to bank regulationFT

Waiting until there is a crisis and then deploying ad hoc measures is not good enough

Mervyn King was governor of the Bank of England from 2003 to 2013. (See his most important books following this post.)

King makes an impressively simple case for a new regulatory rule structure that goes to the heart of the current 2023 banking crisis. This structure could replace the current rule structure and provide for depositor protection within the rule structure, thus eliminating the ad hoc fix approach in place today for every crisis.

He argues that the current set of regulations misses the mark, banking crises still occur and governments muddle around to resolve by guaranteeing all deposits as did America. And America is worse in its reaction by creation of a 2nd and 3rd layer of Banker of Last Resort.

On this blog I have talked at length about the need to deal with funds mismatch which SVB was a huge culprit. King’s term “maturity transformation (borrowing short-term and lending long-term)” sums it up succinctly.

  • borrowing short term – simple example is a bank accepting deposits that earn high rates (SVB)
  • lending long term – underwriting loans whose maturity date is longer than the deposit borrowing short term.
  • risk – depositors take their money out and without matching this quickly turns into a bank run through panic that the Bank cannot pay the depositors. The banks assets aretied up in long dated loans, ergo a bank run.

Moving to his solution I can capture snippets only here, (because FT is a paid service.)

Mervyn King – FT Opinion

But in the financial crisis the problem was the reluctance of wholesale suppliers of short-term finance to roll over their funding. The lesson is that any so-called “runnable liability” … can result in the central bank having to provide liquidity.

Such bodies (banks, insurance companies, pension funds) must either be prohibited from maturity transformation (borrowing short-term and lending long-term) or given access to central bank liquidity on the terms below.

  1. preventing banks from issuing more runnable liabilities than the central bank is willing to lend against available collateral.
    1. The basic principle is that banks should always have a contingent credit line from the central bank to cover runnable liabilities.

This one simple rule could replace most existing prudential capital and liquidity regulation, as well as deposit insurance. It makes little sense for central banks, as the US has done, to guarantee all deposits in a bank that fails and yet maintain that the upper limit on deposit insurance remains for all the other banks.

Mervyn King on Amazon.ca

Tags #banking-regulation #osfi #Central-Banks #Mervyn-King #maturity-transformation

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