The UK Moves First on Bank Reserves

by: John Lounsbury

Brooke Masters and Patrick Jenkins write at ft.com about new liquidity requirements proposed by the FSA (Financial Services Authority). In the first year, cash and government bond reserves of banks would have to increase by more than 1/3. It is estimated that future years could see reserve requirements more than double. This action is presumably the first of many around the world to move to shore up distressed banking systems. Such moves were agreed upon at the recent G-20 meeting.

This is reminiscent of the move by the Federal Reserve to double bank reserve requirements in the U.S. in approximately one year in 1937. This was one of the contributing factors in turning the largest GDP surge in history for 1934-36 back into a deep recession and continuing the Great Depression.

Of course, better control of bank risks is needed, but getting there through regulation alone has its risks as well. There is no free lunch. World governments have made a joint decision to "rescue" failed banks by using government funds (for many through deficit spending) to strengthen bank reserves. This approach has been chosen instead of embarking on some sort of controlled receivership and reorganization of the weakest banks. The approach taken is one that minimizes the deflation of assets on Wall Street at the expense of deflation of assets on Main Street.

The receivership process would have created more of a shock to Wall Street, but would have created an environment, in my opinion, where the deflation felt on Main Street might have been shortened. The restructured banks would have been immediately in a position to conduct commercial credit activities. That is not the situation today as banks are still scrambling to patch up their balance sheets. Bond investors and other bank creditors have been made whole. Conversion of debt to equity has not been forced by reorganization.

If the reorganization route had been chosen, it would be much less risky to double bank reserve requirements within the span of a very few years. Making these moves when balance sheet issues are unresolved poses potential stresses that may not be resolved except by continued contraction of credit.

When this crisis broke, it seems our governments thought they had a choice to resolve it the hard way or the easy way. The easy way seemed to be to "save the financial system". It turns out the easy way for Wall Street was the hard way for Main Street. The route chosen has preserved some capital interests in the preferred form of debt that should have been converted to equity. In the event that equity resulting was insufficient, the debt capital would have been lost. Doesn't that process fit the definition of capitalism?