ZURICH - The discussion about a new regulatory framework for big banks has quietly died down. At the Bank for International Settlements (BIS), the Basel Committee on Banking Supervision has approved Basel III. In Switzerland, the somewhat more severe regulations of the "too big to fail" model are being implemented. All is well again. The debt crises in peripheral euro countries like Greece may be grabbing the headlines, but at least big banks aren't giving us any more headaches.

Sounds comforting. Unfortunately, it's also inaccurate.

Just take a closer look at the European Central Bank's Longer Term Refinancing Operation (LTRO), which pumped a good trillion euros into the European banking system. There are no precedents to compare this to, but it is possible that the LTRO made it possible for ECB President Mario Draghi to avoid a last-minute serial bank collapse.

During the autumn months of 2011, the inter-bank market in Europe was completely frozen. The banks didn't trust each other, American money market funds were withdrawing their capital, and a string of institutions was having refinancing difficulties. The LTRO program relieved the banks' acute liquidity needs. So far so good.

But what the program didn't do was solve the underlying problem: bank solvency. European banks are under-capitalized – so then, as now, the systemic risks are huge.

When it comes to systemic risks and bank regulation, Martin Hellwig, director of the Bonn-based Max Planck Institute for Research on Collective Goods, is one of the clearest-thinking and most far-sighted economists in Continental Europe. On Wednesday, at the invitation of Professor Hans Gersbach, he was guest lecturer at the Zurich campus of the Swiss Federal Institute of Techonology, and his subject was "Banking Regulation and Financial Crisis."

"Basel 3 should really have been called Basel 2.01," Hellwig says, adding that Basel III regulations go nowhere near far enough.

And a crucial basic concept remains unchanged: as before, banks are allowed to conduct risk evaluations of their investments based on their own models – even though the 2008 banking crisis clearly showed that these models (not least in the case of UBS) often fail completely. If the will to make the system significantly safer is really there, Hellwig says, then banks must be forced to maintain a capital ratio of 20 to 30% of un-weighted total turnover. Basel III, however, sets the minimum capital ratio at 3%.

Hidden subsidies

A standard argument on the part of the banks is that their own capital is very expensive, and that they would have to cut back massively on loan-giving if they were forced to hold on to more cash. To Hellwig, these arguments are just plain wrong. In two excellent 2010 papers he produced – partly in co-authorship with Anat Admati, Peter DeMarzo and Paul Pfleiderer - he goes through the arguments of the big banks point by point.

One of Hellwig's core arguments is based on the Franco Modigliani/Merton Miller theorem on capital structure. Greatly simplified, this holds that a company's financing costs are unrelated to how much of their capital is their own, versus how much is money that comes from outside. What that means concretely is that a bank‘s own capital is only expensive because they hold on to so little of it, which thus makes risk premiums high. If a bank holds on to more of its own capital, risk premiums are cheaper on all of its capital. As far as total capital costs are concerned, there is no change – ergo, no way the standard bank argument can be used as a reason to extend fewer loans.

The Modigliani/Miller theorem doesn't hold entirely in the case of the banks, however, because the latter's capital costs are distorted due to the implicit – and since 2008 also explicit – government guarantee backing them up, which also means that they can get outside capital cheaply. "What it amounts to is a state subsidy, and it distorts the free market," says Hellwig.

Notably, Hellwig compares the big banks to industries that pollute the environment. In both cases, external costs are generated that have to be borne by society. In the case of industry, for example: polluted rivers. In the case of the big banks: the risk that, in case of emergency, taxpayer money is going to be required to save the day.

That is the real irony – or idiocy? – of the big bank dilemma as it has been discussed for the last three years in the United States, Europe and Switzerland. Supporters of higher capital requirements have routinely been placed – on a politically naïve "Right/Left" scale – on the Left. But since when has it been Leftist to be in favor of eliminating hidden state subsidies and market distortions?

Read the original article in German

Photo - Noel Reynolds