Banking and finance are inherently pro-cyclical, a condition exacerbated by a combination of Basel II and mark-to-market accounting. But these latter measures have many advantages, so the need is to devise other counter-cyclical macro-prudential policies. This fragility was further enhanced by a decline in bank liquidity (reliance on wholesale funding) and a shift in govenance from partnerships to limited liability public companies. Some commentators have seen the solution to such pro-cyclicality in the guise of direct constraints on bank activity, such as the promotion of ‘narrow banking’ or limits on bank size. While there are arguments for toughening regulation as systemic risk increases, direct constraints are simplistic; more sensible ideas involve the adoption of better designed macro-prudential regulation, perhaps with some version of banking self-insurance. Quite what the future holds for bank regulation remains, however, to be decided.
