The Prudential Regulation of Banks

"The Dewatripont-Tirole book makes an important point about moral hazard. They note that depositors are not in a position to monitor their bank to make sure it is investing their money in a responsible way. So there’s also a moral hazard problem between the depositors and the bank, which generates a role for regulation. The regulator is a stand-in for the depositors. And its job is to place restrictions on what the banks can do. One vital restriction is to require the bank to be adequately capitalised. As we talked about before, bank owners should be putting up enough of their own money to prevent the bank from taking excessive risks. In other words, the bank’s leverage ratio – how much debt it takes on relative to its equity – shouldn’t be too high. Unfortunately, in the run-up to the current crisis, the leverage ratios of many financial institutions reached extraordinary levels. I view this as a failure of government regulation. The theory indeed makes the danger quite clear. I really don’t know why the message failed to get through to policymakers. Perhaps theorists deserve some blame here. Yes. I suspect that theorists of finance will want to keep a closer eye on the practice of finance in the future. A major task now is to devise regulations that will help prevent this kind of crisis from happening again. Theory will inform this undertaking, but translating the theory into simple, effective, enforceable rules is not a trivial undertaking. And there’s a danger of overdoing the regulation. You don’t want government micromanaging financial institutions. Government is not particularly good at that, and it’s likely to stifle good investment that would otherwise occur. So we’ll have to strike a balance, which government is not always good at doing. Well, I believe that the economists in the Obama administration probably have a pretty good grasp of the principles we’ve been discussing. So I think that in the US there is a reasonable chance good regulation will be formulated. What I’m not so sure about is what will happen when Congress gets into the act. As with healthcare, the administration can propose lots of good, theoretically sound ideas about financial regulation, but whether Congress will pay much attention to these is not clear. We’ll see. I guess I’m cautiously optimistic. Yes, the articles we’ve talked about are certainly relevant here. They suggest that it’s fine to reward bankers with bonuses if things go well, as long as they are correspondingly punished for failure. It’s the absence of punishment on Wall Street, rather than bonuses per se, that has been the problem. That’s why I feel the populist urge to limit bankers’ compensation is somewhat misplaced. Yes, it is satisfying and tempting to put a cap on what bankers can earn. But I don’t see that as getting at the heart of the issue, which is ensuring that bankers’ compensation schemes strike a proper balance between reward and punishment."