There has been no shortage of policy mistakes by both individuals and institutions over the past couple of years — some publicly acknowledged, many more denied, at least in public — but there is a wider and more important aspect of the present crisis that has received less attention.

Very many of the beliefs that were accepted as constituting the framework for central bank and financial regulatory best practice a decade ago have been found to be unsound. They contributed to the present disaster and need radical overhaul.

There is a need for a profound revision of much of the intellectual framework that has shaped our actions over the past ten or fifteen years.

Nowhere is this clearer than in the UK, for the reason that the 1997 settlement that set out policy for central bank and financial regulatory policy in the UK incorporated much of the best thinking (and was influenced by the best thinkers) of the time. But many of the intellectual foundations of that settlement have proved wanting. In particular:

(i) the belief that any institution could address one policy objective only, and that that policy objective should be narrowly defined so that progress should be capable of being measured — hence a narrow objective for the Bank of England of an inflation target, and a separate objective for the FSA in terms of supervision of individual institutions. What was left out was responsibility for systemic effects — those actions which made sense to any single institution but which in aggregate resulted in immense problems developing.

(ii) the concentration by central banks on (increasingly narrowly defined) inflation targets and the consequential insistence that they could not address asset bubbles: that they could neither identify them contemporaneously nor, even were that possible, should they attempt to act against them, but should rather allow them to burst and then act to counter the damage caused by that. The experience of the relatively successful resolution to the bursting of the dot-com bubble gave credence to that theory. It is no longer credible.

(iii) the general belief that the extensive use of financial instruments had succeeded in diversifying risk away from highly leveraged institutions — namely banks — and spread it across a wide range of financial institutions, which made the system as a whole much more stable. This was summed up in the IMF Global Financial Stability Report of 2006 in terms that now appear, at best, quaint: “There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risks on their balance sheets, has helped make the banking and the overall financial system more resilient.

“The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.”

(iv) the belief that there had been a marked improvement in the ability of financial institutions to handle the financial risks they assumed, and a corresponding justification for reducing the amount of capital they had to hold against those risks.

This was based in part on the application of mathematical analyses of risk which concentrated on those parts of risk that provided measurable and objective data — hence the extensive use of value at risk (VAR) as a basis for calculating risk and the extensive use of ratings, both of which were fundamental to the work of the Basle Committee.

This was not a problem confined to Basle 2 but affected the whole of the work of the Basle Committee over the past 15 years. It was not the result of political influence, nor of any dissembling by the firms affected. The intellectual failure was shared by practitioners, central bankers and regulators.

(v) deposit insurance schemes — certainly in the UK — had been devised with the problem of moral hazard at the forefront, very much influenced by the US experience of the savings and loan crisis, and with little attention paid to the realities of what would be needed to prevent a crisis of confidence — as the experience of Northern Rock showed only too clearly.

All these things need to be re-examined. They have been at the very centre of how we have sought to regulate and supervise the financial system. But the model has failed and needs redesign.

Nowhere is this clearer than in relation to a central question for bank regulation, namely how much capital should banks hold.

It is clear that in future we will want banks to hold more capital than the present standards demand (at the end of 2007, of the top 40 banks in the world, only two had tier 1 capital below the well-capitalised 6 per cent requirement; the four banks that would in effect fail within the next year had tier 1 ratios of 7 per cent or higher, and solvency ratios of 11 per cent or more, well above the minimum), but it is neither clear how much more, nor even the basis on which that decision will be made.

First, there are institution-specific questions. It’s now recognised that we have very substantially underestimated the amount of capital to be held against the trading book.

But do we require a bank that pays substantial bonuses to hold more capital, and should this be influenced by the structuring of the bonus payments?

Do we require larger banks (under present rules favoured because of the diversification reductions in risk they claim) to hold more capital because they cause more harm if they fail, and are, therefore, more likely to benefit from state support to prevent that failure?

Do we require banks to hold more capital as a function of the degree of concentration in banking in any country?

Second, there are questions that are not institution-specific but relate to macroprudential issues: should we vary the amount of capital that we require any bank to hold, not as a function of the risk to the stability of that bank, but as a function of what is happening in the economy, so that, for example, we would require banks to hold more capital on the upslope of the business cycle, or more if they were judged to be contributing to asset bubbles?

Do we require banks whose assets are large relative to the GDP of the home country to hold more capital than if those banks operated in a country where banking made up a smaller proportion of GDP?

Last, there are methodological questions which need to be answered if we are to translate the answers we reach on the approach to capital into practical guidelines and controls.

I think it clear that there will in future be much less reliance on VAR as an essential tool in setting bank capital, and more reliance on stress testing — easier said than done, since there is no agreed basis for what should be in any stress test; and that there will be greater emphasis on core tier 1 capital, something with important implications (there are major banks whose core tier 1 ratio is less than a third of their tier 1 ratio including hybrid instruments).

There is a debate over whether we introduce a leverage ratio test (it would require substantial changes: of the world’s largest 40 banks, in July last year only 12 would have met the well-capitalised test and 23 the adequate capital test used by US regulators).

Five years ago, central bankers and regulators thought we knew how to set capital requirements for banks. Now we know we don’t. It is but one example of the scale of fundamental rethinking we must do to establish the better intellectual framework needed to secure a safer financial system.

Sir Callum McCarthy is former chairman of the Financial Services Authority

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