15 December 2007

Call to relax Basel banking rules

The Government must suspend a set of key banking regulations at the heart of the current financial crisis or risk seeing the economy spiral towards a future that could "make 1929 look like a walk in the park", one of Britain's leading economists has warned.

Peter Spencer, of the Ernst & Young Item Club, said conflicts caused by the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.

The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.

He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".

Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.

"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."

He dismissed as "window dressing" the move announced by central banks around the world this week to pump extra money into the money markets and increase the type of collateral they will accept in return, in an effort to get them running again.

"This won't get to the core of the problem: the fundamental lack of collateral. As these problems drag on, the consequences for the macro-economy of not relaxing [the Basel regulations] are unthinkable."

Not only do the regulations, which stipulate that banks must have a minimum of 8pc capital among their liabilities, deter banks from lending to each other, they will also limit the amount they can lend to households and businesses. This could escalate the anticipated economic downturn next year significantly, he said.

His warning follows a speech from Bank of England markets expert Paul Tucker, who said changes to these banking regulations were one of the weapons at his disposal in dealing with the credit crisis. Prof Spencer said that although Basel II - an updated version of the accord - may loosen the regulation slightly, it is unlikely to be enough to improve the situation.

"The Bank is staring into the abyss," he said. "The Financial Services Authority must go round and check that all banks are solvent, and then it should cut the Basel capital requirement level from 8pc to about 6pc. "Until then, with the money markets frozen, the Bank will have to go on being the lender of first resort, rather than of last resort."

© Graham Bishop