Regulating banks calls for attack on inertia

At the Group of 20 summit in April, there was wide agreement on the main areas for regulatory reform: more and better-quality capital, countercyclical requirements, a wider regulatory net and a drive to bring more trading on to exchanges. There is less clarity on how radical those reforms need to be. Is it enough to plug these gaps, adjust the dials in the risk models and then get back to business as before?

In my view, three problems do call for more fundamental changes. The first is moral hazard. The Bank of England was criticised for worrying too much about this in 2007. Our timing was poor but the issue was real then and is much more significant now that ambiguity about the state's willingness to let banks' creditors suffer has been largely dispelled.

Of course, banks have had a terrible shock. They do not need telling that subprime mortgages can damage their health. They know that their risk management systems prepared them only for showers, not hurricanes. If they show signs of forgetfulness, at least for the next few years, their investors will remind them.

However, markets provide banks enjoying implicit or explicit government backing with more and cheaper credit than others, enabling them to expand more quickly and take bigger risks. In the short term, of course, that is part of the cure, but it could make the next cycle even more damaging. For market pressures will push all banks, not just the reckless, to make use of easier credit. Already, investment banks are competing for staff with pre-crisis levels of guaranteed bonuses and share options.

So we need to rebuild discipline and establish a credible risk of loss, at least to institutional creditors. That means redesigning insolvency regimes so that they can be used for complex banks and conglomerates. With the new Banking Act, the UK has caught up internationally; but the US Treasury is proposing to go further and we must be ready to follow. We should also follow the US in setting higher capital and liquidity requirements for institutions that receive a "systemic" discount on market funding.

The second problem is regulatory capture and "groupthink". It is not so much that the private sector is full of clever people who pull the wool over supervisors' eyes - although some of that goes on - but that banks and regulators are in constant discussion and negotiation and tend to develop shared views and shared misjudgments, as they did on structured credit and wholesale funding.

We need a second opinion and challenge from a body that is not involved in day-to-day supervision but can take a view of the system as a whole. In the UK, the Bank of England already plays a role of this sort but without any formal authority to give bite to its views. If, as I favour, we introduce a power to vary capital and liquidity requirements with the economic cycle, the Bank should have the lead responsibility for making those judgments. That would put beyond doubt its central role in maintaining financial stability after some years when that role has been in question, not least inside the Bank.

The third problem is regulatory arbitrage. In my view, the European Union has identified most of the right answers here: tighter rules coupled with an effective international quality control on national implementation, an arbiter in cases of dispute and a powerful body to monitor and make recommendations on the stability of the system. But it is not sufficient and may be counterproductive to pursue these for the EU alone. They need to be at least extended to the G20. It does not make sense to look at Barclays, Santander or Deutsche Bank on an EU basis or to apply a regime to them that does not apply to their main competitors from the US or Asia.

The main risk to this programme is a loss of political focus as fears of depression recede. In my experience, inertia is a much greater risk than overreaction, especially in inter­national policy. In the 1980s, when the Basel committee of bank regulators started its work on capital, the plan was to produce liquidity guidelines too. Discussions were still preliminary when we were hit by the liquidity crisis of 2007. Again, after the failure of Long-Term Capital Management, a Basel working group reviewed the dangers from the failure of a large global institution and called for sens-ible reforms - few of which had been acted on 10 years later. We must avoid repeating such mistakes.