Goodhart argues bail-outs are better than bail-ins

New financial regulations bring with them a raft of unintended consequences, some of which may make the financial system less stable than it was already, according to panellists at a debate at the London School of Economics (LSE) last night.

Charles Goodhart, a professor of economics at the LSE and former member of the Bank of England's Monetary Policy Committee, Matt King, managing director and global head of credit products strategy at Citi, and Jon Danielsson, director of the Systemic Risk Centre at the LSE, came together for a panel discussion on new financial regulations and how they may fail to do their jobs.

The subject of bail-ins – converting debt to equity to recapitalise failing banks – proved controversial. Goodhart argued that it was better to make taxpayers take the loss for bank recapitalisation, since investors can flee at the first sign of trouble, and may not be willing to take on the risk in the first place. "If you have a massive downside exposure and no upside, you are not going to buy that bond," he said.

King, however, disagreed. He said making bondholders take the losses might be difficult in the short run, but would provide discipline in the longer run. "Is shooting the few every so often a good example to the others?" he mused.

Furthermore, bail-ins could be a valuable crisis measure. "Once you converted all of these bonds to equity, that institution will look very well capitalised," King said.

When we find that's a total disaster we will have to try something else

Goodhart admitted that bail-ins looked likely to be tested by authorities, whether or not they were a good idea. "We probably will try this bail-in lark," he said. "When we find that's a total disaster we will have to try something else."

Another problem area was the Basel III framework. King said banks would always find a way to optimise their profits on the basis of the latest rules, and would always create a new source of systemic risk.

"In many respects, markets are already becoming distorted as people try to comply with a variety of ratios... this is having slightly awkward side effects in terms of the shortage of safe assets to present as collateral," he said. He noted that sovereign debt, a favoured "safe asset" as it was treated as having very low or zero risk by many regulators, had recently been shown to be highly risky in some cases.

Danielsson said Basel III represented a failure by regulators to adapt to the global financial crisis. "The authorities, rather than questioning why the regulations failed, are now doing more or less what they did before, but more intensively," he said.

He added that Basel III "defines where the light is", meaning that it is easy for banks to move activities into the unregulated shadows.

Banking separation also enjoyed its share of problems. Goodhart pointed out that retail banking, assumed to be fairly safe by regulators, contributed to most of the recent financial crises through excessive mortgage lending.

Curtailing access to the investment arm of the bank also reduced the opportunity to diversify assets. King said the Volcker rule's ban on proprietary trading had not improved stability, but it had made markets less liquid.