The inherent contradiction of regulation exposed (again)

A few weeks ago, Reuters reported that a new research report (I can’t seem to find the original paper, which is still a work in progress) published by two German academics (Wolfgang Gick and Thilo Pausch) recommended that bank supervisors “withhold some information when they publish stress test results to prevent both bank runs and excessive risk taking by lenders”.

I have pointed out multiple times that this was an intrinsic problem to bank regulation, and that Bagehot had correctly identified the issue already in his time. Our societies have, since then, tried to conveniently forget Bagehot’s wise remarks.

Reuters continues:

If depositors know from the watchdog that banks are in trouble, they will withdraw their cash, threatening lenders’ survival and causing the panic the supervisor is trying to avoid, the paper said.

Exactly. And wholesale markets are even more at risk. The authors then recommend that “the amount of information disclosed by supervisors should decrease the more vulnerable the banking sector is expected to be.” Is this going to correct the problem? Evidently not. As the public starts to understand that ‘less information about a given bank’ equals ‘riskier bank’, withholding information from the public domain will become self-defeating.

The authors also correctly highlight that

giving banks a clean bill of health also carries risks, according to Gick and Pausch, by encouraging depositors to leave their money in banks. That would undermine market discipline and lead lenders to take excessive risks, they wrote.

In the end, whatever regulators do, negative consequences follow.

Another contradiction was exposed last month when Ewald Nowotny, Governor of the Austrian central bank, warned that proposed changes to the Basel regulatory regime were “dangerous” because borrowing “could become harder for SMEs.” He added that the revised Basel framework had “a sort of bias against bank lending”, and that “banking regulators should analyze the combined effect on the real economy of the multitude of rules that are due to come into force.”

He is both right and wrong. Wrong because the Basel rules have not been loose for corporate lending since Basel was put in place in the 1980s. It’s precisely the opposite. Rules were stricter than for many other lending types, such as real estate lending, leading to the great credit distortion we have experienced over the past couple of decades, and the slow recovery as corporations were starved of credit (see many many of my previous blog posts for details).

But he’s right that the revised Basel framework will perhaps exacerbate this situation by widening the spread between the capital cost of SME lending and that of real estate lending.

This is where the great contradiction lies. Nowotny is one of the first top regulators to underline a part of the credit allocation distortion. Yet most regulators believe that higher capital costs are justified on the basis that SME/corporate lending is inherently riskier. They never admit that the Basel framework played a major role in creating the great real estate credit bubble that led to the crisis. They constantly, and stubbornly, deny that Basel’s risk-weights could have any impact on the credit supply (and hence the sectorial interest rate). Yet, they contradict themselves when, at the same time, they consider lowering those same risk-weights on a number of products (such as securitisations) to boost…their supply and demand!

Let me get this straight: risk-weights are an instance of price control (in this case, capital cost control). And economic theory clearly demonstrates that price controls are both inefficient and leads to economic distortions. You can’t stabilise the financial system using price control tools, and then blame financial institutions and economic agents for rationally reacting to your measures. You just can’t.

Update: I originally used the term ‘price-fixing’ above. I then thought ‘price control’ was more appropriate, so I modified the post.