A biblical lesson for today's bankers

In a talk to European bankers last month, the governor of the Bank of Spain cited a Bible story to illustrate how modern economies might ameliorate the tendency for busts to follow booms in the business cycle.

Miguel Fernández Ordóñez spoke of Joseph's interpretation of a dream by Egypt's Pharaoh of seven fat and seven lean cows as indicating seven years of "great plenty" followed by seven years of "famine" (Genesis 41). As a result, Joseph was put in charge of the kingdom and set aside a fifth of the harvest in the years of plenty. Thereby, he got Egypt through the following hard times and saved his own family from starvation.

Bringing the biblical idea up to date, Governor Ordóñez suggested financial regulators insist that banks build up their capital at an enhanced rate during prosperous years to put them in better financial shape should a serious slump follow with many boom-time loans turning sour.

Actually, a predecessor of Ordóñez in the 1990s, Governor Luis Angel Roja, did just that. He put into practice a regulatory mechanism termed "dynamic provisioning." This, notes Ordóñez, has reinforced the present stability of the Spanish banking system "and today commands wide recognition."

The biblical story indicates that economies are "unequivocally cyclical," notes Ordóñez. Since Joseph, 4,000 years ago, "perhaps we have made some progress … it seems that the years of plenty are somewhat longer than the lean years," he adds. "But little more than that."

Ordóñez gives credit to William White, a former chief economic adviser to the Bank for International Settlements, a bank based in Basel, Switzerland, owned by the central banks of industrial nations, for promulgating the idea that private banks must specially build up their capital in good times.

Caught on his cellphone in Rome, Mr. White explains that banks have a tendency to ease prudential credit restraints in times of good news, a bustling economy, and rising prices of homes, stocks, and other assets that provide the collateral for even more loans of a shaky nature.

"Rational exuberance turns into irrational exuberance," he says, using a phrase made famous by the former chairman of the Federal Reserve, Alan Greenspan. "Justified optimism turns into unjustified optimism … good times get hyped up."

This led, in present times, to the widespread development of fancy new financial instruments that have added to the seriousness of the present bust in the economic cycle. "The credit cycle has to be resisted," White cautions.

Unfortunately, he notes, Mr. Greenspan and others in the United States warded off vigorous regulatory attempts to dampen the credit boom, holding that the free market decides on values and on buying and selling decisions.

"But sometimes the market does get carried away," he warns. "It is the job of the authorities to maintain some order." They have to lean against tendencies toward asset bubbles and deteriorating credit standards.

But White doesn't see such prudential measures as easy. Financial institutions usually have major political clout and tend to resist any rules that lessen their immediate profits. So regulators must have the will to take a "rule-based regulatory approach."

As for dealing with the "toxic waste" in financial derivatives, "We have to clean them up," says White.

One idea being floated to stop that problem from happening again comes from Harald Malmgren, an economic consultant in Washington. He suggests that the Securities and Exchange Commission require all forms of securitized debts be standardized. They should have "a serial number, name of issuer, and adequate explanation of contents so as to identify the issuer in the event that civil or criminal liability is brought into question," he writes in an e-mail.

Benjamin Friedman, a Harvard University economist, suggests tighter regulations on investments that banks hold "off their balance sheets." This maneuver currently allows banks to avoid the costly regulatory requirement to keep reserves against possible losses.

If banks have any obligation to stand behind such investments and take them back in a time of trouble, then they should not be allowed to place them off their balance sheet, Mr. Friedman says.

Regulators should be more prompt in investigating and correcting any "systemic risks" taken by financial entities, he adds.

Edward Kane, a financial expert at Boston College, urges Washington to set up a game plan to deal with an infrequent spate of financial insolvencies, much as a fire department drills itself on how to fight a spectacular and dangerous blaze. And he wants more attention given to the incentive system in Wall Street that encourages a get-rich attitude and ignores the extra risks involved.