We need a new approach to banking regulation

The writer was Governor of the Bank of England from 2003 to 2013

Fifteen years ago, the collapse of the Western banking system led to the adoption of thousands of pages of complex regulations. Yet here we are in the midst of a new crisis of confidence in banks. Silicon Valley Bank and Credit Suisse had idiosyncratic issues. In the latter case, weak regulation and procrastination by the Swiss authorities have exacerbated the problem. In the first, the contagion affected other small banks.

Banks are inherently fragile – they turn safe, short-term funding into risky, long-term lending. It’s the alchemy of the banking system. The speed at which these short-term liabilities can run means banks can be there one day and gone the next. Most of the time, however, the bank provides a cheaper supply of capital to finance the actual investment.

The experience of several centuries bears witness to the attractions of banking as a means of financing investment, as well as to its weaknesses. Can we retain these benefits while reducing or even eliminating costs? Yes, provided that a framework is put in place governing the provision of central bank liquidity, the only reliable source of liquidity in the event of a crisis.

For too long, central banks and regulators were content to wait for a crisis to then deploy ad hoc measures, inventing as they go. Once a panic has started, liquidity is needed to put out the fire and prevent widespread contagion. But the provision of free insurance after the fact is also an incentive to take excessive risks, leading to ever larger fires.

In 2023, the focus shifted to managed by depositors, which has led to suggestions in the United States and the United Kingdom that the upper limit of insured deposits should be raised. But during the financial crisis, the problem was the reluctance of short-term financing wholesalers to roll over their financing. The lesson is that any so-called “enforceable liability” – such as deposits that can be quickly withdrawn or anything redeemable on demand – may require the central bank to provide liquidity.

The traditional role of lender of last resort played by central banks became obsolete when commercial bank assets began to include “bad” collateral, which could not be valued in the short time required to counter a run. What can replace it?

Governments and central banks need to answer two questions.

First, which institutions should have access to central bank liquidity? Commercial banks are certainly eligible – their deposit liabilities constitute the bulk of the stock of broad money. Any doubt about its safety would expose the economy to violent movements in the means of payment, leading to sharp contractions in production and inflation. But society may also be concerned about the safety of insurance companies, pension funds and other financial intermediaries. These bodies must either be prohibited from maturities transformation (borrow short-term and lend long-term), or have access to central bank liquidity under the conditions below.

Second, how can we limit the scale of central bank liquidity provision in a crisis to avoid taxpayer-funded bailouts? By preventing banks from issuing more executable liabilities than the central bank is willing to lend against available collateral.

The basic principle is that banks must always have a conditional line of credit from the central bank to cover executable debts. Each bank would decide how much of its assets it would pre-position with the central bank. For each type of asset, the central bank would calculate the “haircut” it would apply when deciding how much money to lend. It would then be clear how much central bank money the bank would be allowed to borrow. A bank’s effective liquid assets must exceed its executable liabilities.

In effect, the central bank would be a pawnbroker for all seasons (PFAS). Haircuts would remain fixed for a long time, and on risky assets would therefore be conservative. Doing haircuts is not a task well suited to emergency situations. Banks would be free to decide the composition of their assets and liabilities, all subject to the PFAS rule. Basically, no run could bring down a bank because there would always be cash available to cover all executable debts.

The PFAS rule is not a pipe dream. Paul Tucker and encouraged banks to pre-position collateral after the financial crisis, and the Bank of England has been at the forefront of such policies ever since. Moreover, the expansion of quantitative easing mechanically led to a substantial increase in commercial bank deposits at the central bank. The extent of quantitative easing has been such that if PFAS were introduced today, it would require little change in most major banks’ funding and therefore in their credit offering.

This simple rule could replace most existing prudential capital and liquidity regulations, as well as deposit insurance. It makes little sense for central banks, as the United States has done, to insure all deposits of a failing bank while maintaining that the upper limit of deposit insurance remains for all the other banks.

The regulatory reforms that followed the financial crisis were little more than a band-aid. The system now requires a simpler, less expensive but comprehensive approach to providing central bank liquidity.