Arnold Kling  

European Banks

The Moral Case for Allowing Ki... A Pithy Sentence...

Hyun Song Shin writes,

The permissive bank risk management practices epitomized in the Basel II proposals were already widely practised within Europe as banks became more adept at circumventing the spirit of the initial 1988 Basel I Accord. Basel II was subsequently codified most thoroughly in the European Union through the EU's Capital Adequacy Directive (CAD). In contrast, US regulators have been more ambivalent toward Basel II, and chose to maintain relatively more stringent regulations (at least, in the formal regulated banking sector) such as the cap on bank leverage.

As I read it, the upshot of this paper is to draw attention to Europe as the locus of the Minsky/Kindleberger euphoria.* Shin suggests that the creation of the euro in 1999 is what kicked off the huge expansion in the balance sheets of European banks.

*Tyler Cowen prefers to call this Austro-Austrian.

A lot of economists would say that you cannot shrink those balance sheets without causing horrible macro effects. That view, in turn, would justify a bailout. I am a holdout against that view.

Tyler Cowen cited the paper, which had been first cited by Paul Krugman. In this case, all of us agree about the paper's implications, namely. . .have a nice day.

COMMENTS (3 to date)
v writes:

I would be interested in seeing Arnold address the idea that if an industry is critical enough to require a bailout from the public treasury, then it should not be a private industry at all (i.e., socializing losses, privatizing profit). Even the Left opposes outright nationalization now but the logic of it is difficult to refute.

The best counterargument I can would involve the idea that regulation could mitigate some of the bad effects while still preserving the positive aspects of private ownership but there seems to be little evidence that regulation works or will work in financial services.

jjoxman writes:

Is the paper trying to say Basel II was the problem, or circumventing regulation was the problem?

If Basel II is the problem, why didn't Canada blow up like other Basel II signatories?

mark writes:

Jeffrey Friedman's book Engineering the Financial Crisis, which you've praised, has a slightly different take, as I think you know. That bank capital regulation, beginning with Basel I and reinforced, not corrected, by Basel II, steered large money center banks into certain kinds of debt - mortgages, sovereign and rated securitizations - by assigning lower risk weights to those classes (as classes, regardless of the individual credit worthiness of individual issues in a class) and thereby requiring less capital to be allocated to them, meaning greater lending volume in those classes, and so a feedback loop was created, in which the demand for those classes kept ratcheting upward, leading to CDOs of CDOs etc. I would be interested to see his take on this paper.

I think it is a good idea for people to focus on European banks rather than US banks as it will dispel many populist myths about US banks' purported mismanagement / culpability in relation to those asset classes. But this paper seems to say US bank regulators did a good job in reining in US banks' risk and balance sheet expansion. That doesn't seem accurate. I think Friedman is closer to the mark.

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