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Now there is a big change in financial regulation rooted in a more recent crisis, the credit crunch of six years ago. Since the start of April, the financial policy committee (FPC) of the Bank of England has had a statutory duty to protect and enhance the stability of the financial system. Alongside it at the Bank is the new Prudential Regulation Authority (PRA). Its job is to promote the safety and soundness of banks, insurers and large investment firms by focusing on the problems they cause for financial stability. This is a new direction for financial regulation.
The PRA’s new approach is designed to counter the risk that policy is too accommodating in upswings and too harsh in downturns. Two important principles stand: first, that there is need to carry out financial regulation with an eye on conditions in the real economy, which means promoting stable and sustainable credit creation and growth; and second, there is always need to be prepared to look to the risks ahead, and exercise sensible judgment.
The FPC has recommended that British banks make sure their capital level is high enough to withstand future threats. Some banks will need to increase their equity capital for a given level of risk in their balance sheets.
Concerns have been expressed that this change will harm lending to the UK economy. I do not agree with these concerns. Equity capital is not money that has to be stashed away for a rainy day and thus put to no good use. It is the shareholders’ stake in the company. In non-financial companies, shareholder capital or equity is used to finance the acquisition of assets.
The same is true for banks. Equity finances the provision of loans to households and companies, and those loans are the banks’ assets. In that sense, capital supports lending by banks and does not substitute for it. Higher capital requirements ensure that enough of the finance raised by banks is in a form that can absorb losses without the banks failing.
Higher levels of capital enable banks to attract other non-capital funding, in turn making it easier for them to lend to households and businesses. At present it is the better capitalised banks that are expanding lending.
The crisis has been fundamentally a product of banks that grew rapidly and failed to back that growth with sufficient capital to bear the losses. The FPC has recommended that banks should ensure that they take the necessary steps to put our system in a place where it can support the economy without compromising its stability.
The Bank of England has taken steps to extend the Funding for Lending Scheme, and within that has acted to provide a clear incentive to stimulate lending by banks to small firms. But banks that are short of capital cannot increase lending. That is why in March the FPC made a series of recommendations to ensure that UK banks are well capitalised, and that banks meet that requirement in a way that does not hinder lending to the economy.