Financial Times
January 4, 2012
The Great Fire of 1666 which devastated London originated with a small flame, which spread rapidly across crammed wooden buildings. The loss was immense. What did city elders do to avoid a repetition? Force households to keep a bucket of water, or mandate city houses henceforth to be built from bricks and stone?
The correct answer is B. It was more expensive, but essential. I am sure many Londoners objected to the higher cost. But buckets, while fine for villages, are not for cities of closely connected buildings. Bricks and stone stop fire spreading.
Now, as the strength of Europe’s banking sector is again a subject of highest concern, the 17th century analogy is all too relevant for policymakers. Four years after the world’s banking system nearly burned down, Europe must still confront the risk of a destructive force as it ratifies – ahead of other jurisdictions – the new “Basel III” rules for financial architecture. Higher capital requirements (stone foundations) and tougher liquidity rules (fire-resistant buildings) must restore resilience, moving banks away from a failed model, which relied on too much credit using unstable sources of liquidity (flammable material).
But we cannot wait for the Basel III builders. Under the new rules, the liquidity coverage ratio, which requires banks to hold stocks of liquid assets, does not take effect until 2015. This is not enough. Recently, liquidity buffers have been quickly run down, without ending the conflagration. The truth is that there is not enough safe sovereign debt in the world. Making the “water buckets” larger by allowing more assets to qualify as “liquid” may not help much. Only central bank “hydrants” stop runs, but they ultimately debase the currency.
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