Sean O'Grady: Bank's plan is perfect, and flawed

Excessive leverage turned what should have been an adjustment into a credit crunch

Just as the world suffered grievously from the banking sector's ability to invent complex securities that no one understood, and thus were impossible to manage or value, are we now about to create a regulatory system that is also too complicated to understand? Yes, by the looks of the latest Bank of England contribution to the debate, a discussion paper with the utilitarian title The Role of Macroprudential Policy. It is by Victoria Saporta, head of prudential policy at the Bank, and she welcomes comments. So here goes.

That ugly word "macroprudential" cloaks a simple idea, and one that can do good. It means that the banking system as a whole, and perhaps some institutions in particular, would be required to put more money aside during boom times, which can then be used to support lending during slumps – "capital surcharges". You can see how this might be a neat way of solving the riddle of the credit cycle; it would, in theory at least, have made the boom a bit less boomy, and made our present slump a bit less severe.

Banks act as a pro-cyclical influence on an economy, making good times more peaky and bad times worse, generating all sorts of economic and social imbalances. When company and personal pension funds and people's homes gyrate as much as they have recently, that is in itself an economic cost, making companies and individuals more risk-averse, less entrepreneurial and less wealth-creating. Not to mention mass unemployment. Nor the cost of rescuing the banking system. Or put it this way. The banks aren't lending now because they are basically bust. How much nicer it might have been had they put a bit aside for this rainy day and were now able to lend us money when we actually need it.

Sounds good? Well, it can work, at least up to a point. The Spanish were one of the few nations to impose such a regime on their banks, and it is credited with having kept them out of as much trouble as their counterparts elsewhere. The Spanish system of "dynamic provisioning" did not prevent their real-estate boom, nor even moderate it much. It did, however, make sure that the Spanish banks did not get their fingers too badly burnt when it went sour (and thus left the likes of Banco Santander in a position to gobble up much of our failed retail banking sector – adding Bradford & Bingley and Alliance & Leicester to their Abbey business).

The Spanish system is fine as far as it goes, but it looks easy to circumvent, only applying to banks' conventional lending books for example, and it didn't prevent a credit boom anyway. Proper macroprudential regulation is a much bigger deal than that. And that's the problem.

Enthusiastic as the Bank's paper is about macroprudential regulation, it only really proves the old adage that the best is the enemy of the good. Ms Saporta, on behalf of the Bank, has created a perfect paper system of macroprudential regulation, a sort of Weimar Republic constitution. Perfect, that is, but fatally flawed.

This is because the system has to be partly arbitrary, the product of human judgements. Yet it must also be internationally based and not discriminatory to any nation's proud banks striving, as they do, for global dominance and the right to build the tallest tower in London's Docklands. There is a contradiction there. A rules-based system would be fair to all, and could gain cross-border assent as do the Basel conventions, but would be rigid and clumsy; a discretionary system would be impossible to enforce.

Like moving interest rates, macroprudential regulation must be partly a matter of human judgement, taking into account all manner of factors. Ms Saporta mentions quite a few, including credit flows, income and capital gearing of firms, households and banks, unemployment, spreads on leveraged buy-out deals, a "granular geographic breakdown" of banks' books, house price inflation and quality of loan books. A full list, but one that with each additional indicator moves further from objectivity on the road to subjectivity. Ms Saporta is wrong to think that these criteria – human discretion and international integrity – can be reconciled through openness and accountability. She calls her compromise "constrained discretion", but it looks unworkable, more a contradiction in terms, and impractical.

One can only imagine, for example, the reaction of the outspoken boss of Deutsche Bank, Josef Ackermann, if his institution has an additional capital surcharge slapped on it, effectively a tax, because it is pursuing some particularly profitable line of new business in, say, China that Barclays and Citi haven't quite woken up to yet. Macroprudential capital surcharges can easily be portrayed as a tax on innovation by the envious, and to some extent they are. And which international body will do the regulating? There just isn't one.

Second: How to make such a system work predictably? Again, Ms Saporta explores the issue with impressive thoroughness – the "reaction function" in the jargon – but again there seems no answer. It would be especially irksome to careful institutions who find themselves fined with a capital surcharge because some other players have been spectacularly stupid and imperilled the financial system as a whole. That introduces a new form of moral hazard, and we have plenty of that already. While monetary policy is relatively easy to understand – move interest rates for a given inflation objective – with macroprudential policy no one knows how big these capital surcharges will have to be to restrain "overexuberance". Not remotely. It will, to put it kindly, be a steep learning curve for all concerned. It could turn ugly.

Last, things really are compromised by the vast mind-mincing complexity of the rules. As far as this writer is concerned, any regulatory system that requires three-dimensional graphs to explain it is dead in the water. The Bank's policy document shows a nightmarish "chess in 3D"-style chart, while here we show an equally forbidding image illusrating just how enmeshed the UK's financial system is (and therefore how even relatively small institutions could be thought of as "systemic"). Ms Saporta and Mervyn King may understand all this, but I doubt any mere banker would, let alone politicians or members of the public. Or hacks like me.

Let me end with a more constructive idea. Instead of all this three-dimensional stuff, why not a simple cap on bank leverage? The more one reads about the way the crisis developed – Andrew Ross Sorkin's Too Big To Fail is the latest thriller-like account – the more obvious it becomes that excessive leverage was the biggest single factor that turned what should have been an adjustment into a credit crunch and then a slump. It was not the Spanish who capped bank borrowings, but the Canadians, whose banks and economy were spared the worst of the downturn. Look west, Ms Saporta.

s.ogrady@independent.co.uk