The challenge with this approach is to prevent the costs associated with the activity of maturity transformation from gravitating to another set of institutions – the “shadow” banking system. Whatever solution is adopted, the aim must be to align private and social costs. 5. Why Basel III is not a complete answer  Lauded as a new standard, Basel III is seen by some as the answer to the failure of regulation to prevent the financial crisis. It is certainly a step in the right direction, an improvement on both Basel I and the ill-fated Basel II, and we should all welcome it. But if it is a giant leap for the regulators of the world, it is only a small step for mankind. Basel III on its own will not prevent another crisis for a number of reasons. First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee. More fundamentally, it fails to recognise that when sentiment changes only very high levels of capital would be sufficient to enable banks to obtain funding on anything like normal spreads to policy rates, as we can see at present. When investors change their view about the unknowable future – as they will occasionally in sudden and discontinuous ways – banks that were perceived as well-capitalised can seem under-capitalised with concerns over their solvency.
Nevertheless, there are benefits to this maturity transformation – funds can be pooled allowing a greater proportion to be directed to long-term illiquid investments, and less held back to meet individual needs for liquidity. And from Diamond’s and Dybvig’s insights, flows an intellectual foundation for many of the policy structures that we have today – especially deposit insurance and Bagehot’s time-honoured key principle of central banks acting as lender of last resort in a crisis. If the only problem is one of illiquidity leading to fragility, then central banks can easily act to ward off problems. By demonstrating a willingness to step in to provide temporary liquidity support, then the likelihood of problems arising in the first place is dramatically diminished. It was wholly appropriate that this was the focus of Bagehot’s writings – at the time, the structure of the banking system meant that illiquidity was often the key problem. And central banks did not appreciate the importance of the role that they could play. Bagehot’s whole purpose was to convince the Bank of England to fulfil this role. But the changes in the banking system over the past fifty years mean that a much more diverse range of problems can strike today. In September 2007, everyone thought that the crisis was one of liquidity and as a result there was an expectation central banks could provide the solution. But it quickly became clear that it was in fact a crisis of solvency.