European bank regulation - full of sound and fury

For the European Commission, every crisis is an opportunity to concentrate power and diminish the authority of the member states. Today, it initiated another power-grab. This time, the target is the European financial sector. The takeover strategy is outlined in a document published today - "A Framework for Bank Recovery and Resolution".

The document proposes the creation of a European Resolution Authority. There will also be far-reaching new powers permitting regulators to seize failing banks, fire bank board members, and inflict financial losses on bank creditors. It is all Draconian stuff, but is this what the European financial system needs?

Many things went wrong during crisis and the list of villains is long. However, at the core of the crisis, there were two failures. European banks failed because they had insufficient buffers in the form of capital to absorb losses. Banks also failed because they lacked sufficient liquidity - in other words, cold hard cash. Unfortunately, the European commission's proposals are a little light in these two areas.

It is understandable why the European Commission would avoid these issues. Serious reform is painful. Forcing banks to increase their capital and liquidity levels would be costly in terms of economic growth and financial sector profitability.

Banks have a number of options for increasing capital. None of them are terribly attractive. Banks could slash dividends payments to shareholders, but that will send bank share prices southward.

Banks could boost the interest rate spread between what they charge on loans and what they offer on deposits. Depending on how they did it, this could generate one of two distasteful outcomes. If they raise lending rates, economic growth is likely to suffer. If they cut deposit rates, they will find it difficult to attract funding.

Alternatively, Banks could reduce lending in order to shrink their balance sheet in line with their existing capital levels. This would be a renewed credit crunch, again adversely affecting growth.

Increasing liquidity levels would have comparable detrimental effects on economic growth. Banks could try to books cash levels by reducing their assets and calling in loans. Banks could also move an increasing proportion of their portfolios from illiquid high interest assets to cash. Bank profitability would inevitably take a hit.

The financial sector needs to shrink, become less profitable, and more liquid. Before the crisis, Europe enjoyed a wonderful decade of rapid growth. It was, in large part, built on low interest rates, a lack of proper lending standards, and huge asset inflation. A properly constructed financial sector reform would insure that these things never happen again.

The European Commission - and European politicians generally - are reluctant to go down that road. Instead, a furious sounding but essentially vacuous set of measures offers an easier path. New agencies, rigid regulations, and government interference in the minutiae of financial sector activities - these are the policy equivalent of smoke bombs. They make a loud bang but are quite harmless.