Ratcheting through the cycle

How can future bubbles be prevented? One way is to jack up bank capital in boom times, in order to stop excessive credit growth. The G20 summit in London has just signed up to the idea. In principle, what policy wonks call a “countercyclical” capital regime is an excellent idea. It would not only prevent booms getting out of hand; capital requirements could be lowered when hard times return, cushioning the bust.

The snag is that it could be a lot easier for the authorities to push up minimum capital ratios in a boom than lower them in a crisis. Indeed, in recent months, regulators have said they are happy for banks to eat through their capital cushions – but the market hasn’t paid a blind bit of notice to them. Investors look at banks and think: this is a crisis; you need more capital to deal with it.

Imagine regulators set a minimum core Tier 1 capital ratio of, say, 4% but increased it to 7% during an economic boom. When the next bust came along, investors might not want the ratio to fall below 7%. A countercyclical capital regime therefore risks becoming a ratchet – dampening the upswing but accentuating the downswing. That would be unfortunate.

This is not, however, a reason to give up on the idea. It just needs careful design. A better approach would be to set a minimum capital ratio throughout the cycle – but tell banks in the good times to stash away provisions against future losses. They would build up piggy banks explicitly meant to be emptied on a rainy day. In some ways, such an idea would amount to going back to the future. In the old days, banks used to keep hidden reserves on their balance sheets, to be used up when actual losses mounted. In a new world, though, the size of such piggy banks should be completely transparent,

The difference between a rainy day fund and variable capital ratios is still purely presentational. If markets were totally efficient, both methods would lead to the same result. But everybody knows now that markets are inefficient. Good presentation of a countercyclical capital regime will be the key to its success.