Prudent bankers, careless regulators?

Read the article in the Cayman Financial Review Magazine 


Banks have in essence changed little since they emerged from being early modern goldsmiths. Their key business remains borrowing and lending. When engaged in that they are crucial to the economy in two ways. They supply a part – in modern economies, by far the greater part – of the stock of money. And they transfer funds from lenders to borrowers – they act as financial intermediaries.

When borrowing and lending, they need to hold capital. Capital comprises funds the bank actually owns. It can be provided by the bank’s shareholders, or, according to the corporate form, by the partners in the bank or even by its sole owner1. Such funds are needed because regardless of how well a bank is run, now and again it will lose money on a loan.

That, though, is no excuse, in either morality or law, for not repaying the people who have lent the bank money; so the bank needs some funds of its own to make up what is needed to repay depositors when that is necessary. How much capital should banks hold, and who should decide on the answer to that question?

Capital has always been important to British banks. Indeed, it was considered so important that the government and the Bank of England accepted the public interest argument that allowed the concealment of true profits and capital until as recently as 1970. Banks have always experienced a tension between having too much capital and too

Back in the 1950s British banks wanted to raise more capital, but the Capital Issues Committee, a regulatory body charged with ensuring that there was always plenty of capacity in the capital markets for government borrowing, discouraged them. Now regulators are urging, indeed compelling, them to raise more capital. What has changed?

little. Strong capital positions are designed to give depositors confidence – indeed, in the nineteenth century, they were on occasions used as a competitive weapon to attract deposits. But the greater the capital the lower will be the return on capital and so there is a trade-off between depositor confidence and shareholder satisfaction. And of course the quality of the assets, ie the quality of what the bank has lent against or bought, is key to any calculation.

In the first half of the nineteenth century there were several hundred banks in England. In the periodic financial crises of that period many banks failed, or suspended payment for a time, or merged, or were taken over. There were no regulations as to what proportion of the balance sheet their capital should be. The banks each had to find their own way to the appropriate balance sheet shape for each individual institution.

The banks began cautiously, with very high capital/asset ratios. But these gradually came down as trust and understanding developed. By the beginning of the last quarter of the nineteenth century, the published capital ratios had settled at around 15 per cent, and by the end of the century that figure had slipped to around 10-12 per cent.

In the First World War the ratios fell further, as much of bank lending was secured on government debt, then believed to be completely secure. The ratios fell again, to around 3 per cent, in the Second World War. But as the ratios fell so too did the risk since the bulk of the balance sheet was again made up of gilts. The ratios reached their all-time lows in the 1950s when they were down to between 2 and 3 per cent2.

It is worth pointing out too that these figures are averages across the banks but there was across the period some variation between banks. These variations reflected the different approaches of banks to risk and the different kind of business they conducted.

Raising capital after the Second World War was not easy in view of the restrictions placed by the Capital Issues Committee, a body charged with ensuring there were always plenty of funds available for the British government to borrow. This particular restriction on the banks’ freedom to raise capital began to be troublesome and bank chairmen spent a lot of time in the 1950s lobbying the Bank of England for its support in getting them the freedom to raise new capital.

It cannot be overemphasised, particularly in view of current discussions, that the banks themselves were keen to hold more capital as they began to move away from wartime balance sheets and lending to government to lending again to the private sector. It was government regulation that prevented them doing so.

The first hints of coordinated international bank regulation came in the wake of two 1974 bank failures – those of Bankhaus Herstatt and of Franklin National Bank. These led to the formation of a standing committee of bank supervisors from the G10 countries; it has a permanent secretariat at the Bank for International Settlements in Basel – hence it is also known as the Basel Committee.

This committee started to concern itself with capital regulation in 1988. In that year it established a set of “Capital Adequacy Standards” for internationally operating banks. Their rules became known as Basel1. Changes to these capital regulations were proposed in 2001. Measures of credit risk which recognised that all companies (and countries) were not equally risky were, along with other changes, adopted. Despite this effort, there has been a major banking crisis over a substantial part of the world. What was the response?

Good examples are the Vickers Commission in the UK, and the proposals of a team led by Paul Volcker in the USA. These proposals had much in common. In particular, they proposed to separate investment banking (dealing in markets, essentially) from the traditional banking activities of borrowing and lending. The main difference between the Volcker rule nd the proposals of the Vickers commission relates to the location and height of the fence that divides the different banking activities.

What is notable, praiseworthy and too little emphasised about the recent Volcker and Vickers proposals is that they are a retrograde step. They are gradually moving us back to a pre-regulation era. Central to prudent behaviour in that era was fear of failure. It was that fear that in the 1960s led to the bank chairmen lobbying the Bank of England to be allowed to raise capital. Without the fear of failure, there is no incentive for prudence beyond that provided by virtue, and, at least as importantly, a system which protects incumbents from failure is one where there will be no new entrants.

That is why the division of banks, as proposed both by Volcker and by Vickers, is so important. The division should be thought of not as making banks failure-proof, but rather as making it possible for them to fail in a fashion as orderly as any other firm.

For that reason the proposal of the Vickers Commission that British banks should hold very much higher levels of capital, perhaps higher than the EU will allow, seems to us to be at best beside the point. The support of the British government, the EU and the Bank for International Settlements for higher capital requirements to prevent failure is likewise misguided.

Surely the next and most obvious step is not to impose internationally agreed capital ratios on banks, but rather to recognise that banks, once they are forced by the possibility of failure to take responsibility for their actions, are best placed to judge their own capital requirements. If they do not do so sensibly, they will not be in the business of banking for long. The whole failed apparatus of bank capital regulation can then be abandoned. 



  1. This highlights why building societies, like all mutual organisations, being owned by their customers can face problems when seeking to raise capital, especially if it is needed quickly.
  2. When risk weightings of the Basel type are applied the figures would become dramatically higher, reflecting the quality of the assets the banks held across most of this period. Thus the figures for the 1920s would show Basel-type risk-weighted ratios of around 14 per cent. Those of the Second World War would turn out to be the highest of all time being even higher than 14 per cent. And, in the 1960s, the ratios were of the order of 13 per cent.


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Forrest Capie

Forrest Capie was a British Academy Fellow at the National Bureau in New York and a Visiting Professor at the University of Aix-Marseille and the LSE, and a Visiting Scholar at the IMF.   He was Head of Department of Banking and Finance at City University from 1989-1992; editor of the Economic History Review 1993-1999; a member of the Academic Advisory Council of the Institute of Economic Affairs in London, and an advisor to the Shadow Chancellor of the Exchequer.  He is currently advisor to the UK’s Parliamentary Commission on Banking following the recent global financial crisis.

Forrest Capie
Professor Emeritus of Economic History
Cass Business School
City University London
London UK

T: +44 (0)20 7040 8951
E: [email protected]


Geoffrey Wood

Geoffrey Wood is also a visiting Professorial Fellow in the Centre for Commercial Law Studies at Queen Mary and Westfield College, University of London and has been a visiting professor at the University of Athens. In the academic year 2004-2005 he was Visiting Professor at the University of Oxford. He has served for some time as Special Adviser to the Treasury Select Committee of the House of Commons.  He is on the Editorial Boards of the Greek Economic Review, The Journal of Financial Education, and the the European Journal of Political Economy, and is a General Editor of the Journal of Financial Regulation.  He is also Professor Emeritus of Monetary Economics at the University of Buckingham, and Advisor to S J Berwin LLP.

Geoffrey Wood
Professor Emeritus of Economics
Cass Business School
City University London
London UK

T: +44 (0)20 7040 8740
E: [email protected]


Cass Business School

Cass is a top 10 UK business school for business, management and finance research, offering UG, Masters, MBA programmes, Executive Education and Consultancy. An integral part of City University London, Sir John Cass Business School is among the global elite of business schools that hold the gold standard of 'triple-crown' accreditation from the Association to Advance Collegiate Schools of Business (AACSB), the Association of MBAs (AMBA) and the European Quality Improvement System (EQUIS). We are consistently ranked amongst the best business schools and programmes in the world which, coupled with an established 40-year reputation for excellence in research and business education, enables us to attract some of the best academics, students and businesses worldwide into our exclusive Cass network.  London and Dubai 


Cass Business School
City University London,
London UK

T:  +44 (0)20 7040 8740
E:  [email protected]