Regulators could sow the seeds for the next financial crisis if they focus too exclusively on requiring banks to hold more capital rather than forcing changes in how they are run, a new report warns.

Many banks undoubtedly did not have enough equity and retained earnings – known as core tier one capital – on hand to survive the recent crisis without government help. However, simply raising the requirements will not solve the problems, according to researchers sponsored by the Financial Services Research Forum, a Nottingham University group.

The forum, which brings together academics, industry and regulators to make policy recommendations, argues in a paper released today that improving the way banks manage risk and their complex businesses is far more important.

“The regulator is calling for bigger airbags, but airbags don’t avert crashes – what we need is better driving. We need to address how to stop banks failing rather than weighting the focus on softening any falls,” said Simon Ashby, author of the report and a former FSA policy official.

The Basel committee on banking supervision is rewriting the capital rules and hopes to have them approved by the end of this year.

The proposed changes include tighter definitions of capital, higher capital requirements for risky activities, and proposals to force banks to conserve capital by limiting their ability to pay bonuses and dividends if they get close to regulatory minimums.

Ashby argues higher capital requirements could contribute to the next crisis by making bank investors, creditors and management too sanguine about their ability to survive losses.

Some of the 20 top risk officials he interviewed for his report also pointed out that key sources of the last crisis – securitisation and special purpose vehicles – gained favour partly because they allowed banks to exploit the capital rules. A new regime could inspire similar creativity.

“The FSA and other regulators are focusing too much on the capital requirements and not enough on the risk management side. It is a question of changing behaviour and recognising that [banks] can’t grow unsustainably quickly, even if their capital is growing as well,” Ashby said.

Source: Financial Times