04 January 2012

Enrico Perotti: How to stop the fire spreading in Europe’s banks

In this FT Opinion, Perotti draws a comparison with the Great Fire of London in 1666, and says that waiting for Basel III is not enough. Among still-hot ashes, history should guide planners to rebuild the city of finance wisely.

Four years after the world's banking system nearly burned down, Europe must still confront the risk of a destructive force as it ratifies – ahead of other jurisdictions – the new "Basel III" rules for financial architecture. Higher capital requirements (stone foundations) and tougher liquidity rules (fire-resistant buildings) must restore resilience, moving banks away from a failed model, which relied on too much credit using unstable sources of liquidity (flammable material).

But we cannot wait for the Basel III builders. Under the new rules, the liquidity coverage ratio, which requires banks to hold stocks of liquid assets, does not take effect until 2015. This is not enough. Recently, liquidity buffers have been quickly run down, without ending the conflagration. The truth is that there is not enough safe sovereign debt in the world. Making the “water buckets” larger by allowing more assets to qualify as “liquid” may not help much. Only central bank “hydrants” stop runs, but they ultimately debase the currency.

Central banks should be empowered to apply “prudential risk surcharges” on the gap between a bank’s current liquidity position and the Basel III ratios. These charges compensate for and discourage the creation of systemic risk. Coordinated by the new European Systemic Risk Board, surcharges would start low but be raised when circumstances allow to nudge banks into compliance.

The surcharge would make it more expensive for banks to rely on short-term funding, which will reduce yields for investors. However, this will also correct a major loophole. Right now, wholesale short term funding is de facto insured but evades deposit insurance charges. This may have a slight impact on the cost of credit. But stable credit is less costly than cyclical banking for businesses and taxpayers.

International coordination of surcharge rate setting is desirable. But a level playing field requires that riskier banks face higher charges, or else competition is distorted. Unlike transaction taxes, charges on liquidity risk target the creation of risk itself, contributing to financial and fiscal stability.

Coordinated rate-setting also ensures a common convergence process, in place of each country setting its own transition rules. Rate flexibility in the transition would also reinforce the cohesion of the euro area, reducing the rigidity imposed by a single currency.

Full article (FT subscription required)

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