Taming the banks, but at what cost?

As the world’s financial institutions regroup following the devastating global financial crisis economic policy is under the spotlight. Robert Carling believes many are seeking revenge when they insist on tight new regulations.

Economic history tells us to expect that major financial crises will be followed by lengthy periods of sub-par economic growth, or worse.

The performance of the global economy – and particularly the US and Europe – in the wake of the global financial crisis is consistent with the lessons of history. There is, thus, a certain inevitability about the pain they (and, to a lesser extent, other regions) are experiencing. It is also true, however, that economic policies can make the aftermath of a crisis more or less painful than it needs to be.

While it is difficult to identify countries currently pursuing inspired policies that will strengthen the foundations for recovery, plenty of countries are making things worse. The onslaught of banking and finance regulation is a good example.

There is no doubt that banks took excessive risks; that innovation created complex and dangerous financial instruments; that there was too little capital and liquidity in the system; and that bankers were (and still are) paid too much. But it is an over-simplification to blame the banks and inadequate regulation for the global financial crisis. The causes of the crisis were more complex and varied, and included misguided economic policies, but it is more convenient for politicians to blame others.

Some tightening of regulation in response to the crisis was justified, but we are seeing re-regulation with a vengeance. Revenge is not a substitute for sober analysis as a basis for policy. There is a real risk that banking and finance will be strangled, with serious consequences for the cost and availability of finance for investment. As these new regulatory regimes are likely to stay with us for many years, the economic costs they will impose will be a lasting legacy of the global crisis.

Australia should escape the worst of these costs, because our regulators are sticking to the Basel III script. While Basel III contains some dubious features, such as ‘macro-prudential regulation’, on the whole it represents a reasonably measured tightening-up of regulation. The track record of the Australian regulators suggests that where Basel III leaves them some discretion, they will apply the rules sensibly.

In contrast, the US, UK and the EU are going well beyond the Basel III script. The best example is the Dodd-Frank legislation in the US, which is a hydra-headed monster of regulation. It is slowly giving birth to hundreds of new rules, the latest of which is a 1,099 page directive to lenders on mortgage simplification. The more the major countries do to strangle banks with such red tape, the more they will harm themselves, and the more Australia will suffer indirectly through its links to global finance.

Reserve Bank Governor Glenn Stevens said two years ago that finance has its own cycle of risk appetite, innovation and occasional crisis, which regulation won’t remove.

Whatever limited success regulators have in moderating the cycle of finance will come at the cost of reduced economic efficiency. Financial intermediation and innovation are at the core of long-term economic development. There has to be a trade-off between efficiency and stability, but excessive regulation risks damaging long-term economic growth in a futile attempt to make banking ‘safe’.

Robert Carling is a Senior Fellow at The Centre for Independent Studies, an independent public policy research and educational institute based in Sydney. He undertakes research into a wide range of public finance issues and regularly comments in the media on taxation and other budget issues. Before joining the CIS, he was a senior official with the New South Wales Treasury, and prior to that with the Commonwealth Treasury, the World Bank and the International Monetary Fund. He holds qualifications in economics and finance from the London School of Economics and Political Science, Georgetown University and the University of Queensland.