Most of the injections of public funds would have been unnecessary if banking capital ratios were allowed to fall during downturns, EDHEC argues.
The financial crisis has put great pressure on banks and led to a number of emergency measures intended to restore confidence in the banking system: tentative changes to accounting standards, recapitalisation of the banking industry, and higher capital requirements.
Each measure targets a specific concern that has arisen during the crisis. Governments and regulators, however, have yet to deal with one of the essential causes of systemic risk: the inflexibility of prudential regulation for banking.
As it happens, a single minor change would make it possible to restore much of the confidence in the banking sector without requiring any capital injections in the short term: acknowledging that banking capital ratios fall during downturns would have made most of the injections of public funds unnecessary. Making this change today would give governments far more room to support in the real economy.
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