That seems to produce a better guide to the real financial strength of banks and to be properly conservative in not recognising profit before it is earned. I am aware that this runs counter to a powerful school of accounting theology but I have been encouraged by proposals circulated recently by Paul Boyle at the FRC for cyclical reserving and I hope that will be pursued. An alternative approach would be to vary regulatory capital floors with the cycle and require banks to hold undistributed reserves in the upswing which could be drawn on in the downswing. This is a second best because the reserves are taken after profit is struck, with all the signals that sends investors and staff. But it could have much the same effect as dynamic provisioning and may be capable of implementation rather earlier. But capital requirements are not the only approach. Counter cyclical limits could be introduced on the liquidity position of a bank. For example, banks might be required to invest a varying proportion of their assets in a war-chest of government bonds and highly liquid assets. Or they could face varying constraints on the extent to which they are allowed to tap short-term wholesale funds. Finally we could introduce restraints on the terms on which banks can lend money to households and companies. Loan to income and loan to value ratios tend to rise in any credit boom as lending standards become lax and asset prices inflate.
But the outlines of a scheme are beginning to emerge in the academic literature – not least in an impressive recent report by Charles Goodhart of this parish and friends – and they are being taken up vigorously ( especially by the British members) of the FSF and G20. Preventing the regulatory system from exacerbating the cycle A minimum step is to remove as far as possible features of the regulatory system which exacerbate the cycle. This is not as easy as it sounds. Both accounting rules on provisions and regulatory capital requirements are based on estimated probabilities of default and estimates of losses given default. Both of these tend to rise sharply when an economy turns down, arrears mount and the value of collateral declines. So as trading conditions tighten, capital requirements are raised. The FSA announced last month a series of measures which seek to address that pro cyclicality by basing their capital requirements on average loss rates through the cycle rather than on estimates of loss which vary through the cycle. A similar approach is being ironed out internationally in the Basel Committee and FSF. Protecting the banks from the cycle A more ambitious goal would be to use the regulatory system to dampen the impact of the economic cycle on banks and other financial institutions – to protect the banks from the cycle. The Spanish system of dynamic provisioning is an example of this approach.