Bank regulation and supervision

Can financial crisis be forestalled by strict regulation and supervision?
Some observers advocate such an approach. Others recommend deregu-
lation. Most of the rules for sound banking are already incorporated in
the regulations or are implicit in banking tradition. Many of the rules
are ignored by banks and regulators alike. Banks are supposed to ‘mark
to market,’ that is, value their loans and investments each day (or week
or month) at the price that would be realized if they were sold in the
market rather than at their historic cost. Reserves should be established
against ‘problem loans’ and write-offs against ‘doubtful’ ones. As a bank’s
capital declines as its loan losses increase, the bank might be required to
raise more capital or be closed under the traditional rules. As an illustra-
tion of the unusual character of banks following these rules, the press
was full of the news in the spring of 1987 when Citicorp wrote down
the value of its Third World debt and the FSLIC allowed 500 insolvent
banks to remain open in the hope that they would become sufficiently
profitable to rebuild their capital. As part of the regulation process, the

Federal Reserve Board began to collaborate with other central banks in

the Group of Ten to strengthen bank structures worldwide by gradually

approaching uniform capital requirements and then risk-based capital

requirements.

Emphasis on capital requirements as a percentage of assets or other

liabilities has led some banks to switch to ‘off-balance sheet’ operations.

These transactions generate fees or commissions for the banks, but the

asset or liability is contingent or committed so that it is not shown on

the balance sheet except as a footnote. These off-balance sheet transac-

tions include interest rate and currency swaps, futures contracts, options,

underwriting risks, ‘repos’ (sales of securities with a guarantee to repur-

chase them at a later date), and note-issuing facilities. Each of these can

perhaps be valued as an option or warrant and included among assets or

liabilities when calculating the appropriate amount of required capital,65

but significant financial sophistication is required.

A strong case can be made for stricter regulations and supervision of

banks to forestall lending in euphoric periods that may end in finan-

cial crisis. Historical fact suggests that such a case rests on a counsel of

perfection. The bank examining system in the United States divides re-

sponsibility among the Comptroller of the Currency, the Federal Reserve

Banks, and the state banking commissioners. In one view there is compe-

tition not in deregulation but in reregulation.66 ‘Divided responsibility,’

said a famous German banker-politician, ‘is no responsibility.’67 The as-

tute personnel needed in time of emergency are unwilling to submit to

the boredom of long periods of calm. The mismanagement of banks is

hard to detect before a crisis. In boom, entropy in regulation and su-

pervision builds up danger spots that burst into view when the boom

subsides. The question then is whether to liquidate, stall, guarantee, bail

out, take over, or rely on other means of last-resort lending.

Lady Luck once worked effectively to assist a bank in distress. Wirth

wrote that the Brothers Kauffmann in Hamburg were failing during the

crisis of 1799 when one of the brothers sent his bride a Hamburg city lot-

tery ticket, which carried a first prize of 100,000 marks banco. She bought

the same number in another lottery in the Duchy of Mecklenburg, the

prize for which was an estate worth 50,000 Prussian thalers, then equal

to 100,000 marks banco. She won both, and the Brothers Kauffmann

were fully rehabilitated.68 The odds at Las Vegas may be higher for the

solution to a global crisis.

The hallmark in the development of ‘the Art of Central Banking’ over the

last two hundred years has been the evolution of the concept of a lender

of last resort. The expression comes from the French dernier ressort, and

centers on the last legal jurisdiction to which a petitioner can take an

appeal. The term now has become thoroughly anglicized, and in central-

banking English places the emphasis on the responsibilities of the lender

rather than the rights of the borrower or petitioner.

The lender of last resort stands ready to halt a run out of real assets and

illiquid financial assets into money by supplying as much money as may

be necessary to forestall the run; the concept is of an ‘elastic supply of

money’ that expands to meet the demand in panics. How much money?

To whom? On what terms? When?

These questions are those faced by the lender of last resort and follow

from the dilemma that if investors believe that banks and perhaps other

selected borrowers will be supported in moments of distress by a lender

of last resort, they will be less cautious in the extension of loans during

the next boom. The public good of the lender of last resort weakens the

responsibility of private lenders to ensure that they make ‘sound’ loans.

If, however, in a panic the rush from the sales of securities and com-

modities into money cannot be halted, the fallacy of composition takes

center stage. The sale of these assets by investors in the effort to min-

imize losses leads to declines in the asset prices, with the consequence

that a large number of otherwise previously solvent and well-capitalized

firms may become bankrupt.

The development of the lender of last resort evolved from the practice

of the market rather than from the minds of economists. Ashton asserted

that the Bank of England was already the lender of last resort in the eigh-

teenth century,5 although this pronouncement does not entirely square

with his statement that ‘long before the rules for the treatment of crises

were laid down by economists, it was recognized that the remedy [for

a financial crisis] was for the monetary authority (the Bank of England

or the government itself) to make an emergency issue of some kind of

paper which bankers, merchants and the general public would accept.

When this was done the panic was allayed.’6

The indecision as to whether the central bank or the government was

the final monetary authority remains to this day and qualifies the state-

ment that the Bank of England emerged as the lender of last resort in the

1700s. E.V. Morgan maintained that the Bank of England’s realization

of its responsibility was delayed by the government’s action in issuing

Exchequer bills in 1793, 1799, and 1811, and that the Bank assumed

the role as lender of last resort only gradually during the first half of the

nineteenth century ‘in spite of the opposition of theorists.’7 The same

evolutionary process can be seen in the Bank of France. In 1833 the ma-

jority of the Conseil General overrode Hottinguer’s idea for a policy on

the English model as well as Odier’s plea for an entirely new policy and

concluded that the major function of the Bank of France was to defend

the French franc. Capital outflows were not to be feared. Interest rates

should not be held artificially low or speculation will be encouraged

and crises intensified. When a crisis occurred, however, the Bank should

provide abundant and cheap discounts to moderate the intensity of the

crisis and shorten its duration.8

The role of the lender of last resort was not respectable among theo-

rists until Bagehot’s Lombard Street appeared in 1873, although Sir Francis

Baring called attention to the idea at the end of the eighteenth century 9

and Thornton’s classic, Paper Credit, developed both the doctrine and the

counter-arguments in his discussion of the financial problems of the En-

glish country banks.10 Bagehot traced the origin of the doctrine to David

Ricardo rather than to Baring and Thornton in his statement before the

Parliamentary Select Committee on Banks of Issue in 1875: ‘The ortho-

dox doctrine laid down by Ricardo is that there is a period in a panic

at which restrictions upon the issue of legal tender must be removed.’11

Bagehot himself had articulated the doctrine in his first published arti-

cle, written in 1848, when he commented upon the suspension of the

1844 Bank Act in the panic of 1847:

It is a great defect of a purely metallic circulation that the quantity

of it cannot be readily suited to any sudden demand . . . Now as paper

money can be supplied in unlimited quantities, however sudden the

demand may be, it does not appear to us that there is any objection on

principle to sudden issues of paper money to meet sudden and large

extensions of demand . . . This power of issuing notes is one exces-

sively liable to abuse . . . It should only be used in rare and exceptional

cases.12