Margins Of Error

The Economist ponders banking reform:

Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant of and bored by regulation. The more a financial system depends on the wisdom of regulators, the more likely it is to fail catastrophically.

Hence the overwhelming importance of capital. Banks should be forced to fund themselves with a lot more equity and other risk capitalpossibly using bonds that automatically convert to equity when trouble strikes. Higher capital requirements would put more of the shareholders’ money at risk and, crucially, enable banks to absorb more losses in bad times. Think of it as a margin for regulatory error.