Regulating the banks

Politicians from EU countries are meeting today to discuss methods of banking regulation to prevent a recurrence of recent events.

But neither regulation nor supervision will work. If the problem is to be tackled, this must be at source.

What has happened is a classic cyclic bubble. At the start of the cycle at the bottom of a recession, credit is in quite short supply. Nevertheless, banks lend money for land purchase, usually concealed at property or house purchase, but in which land value is a significant proportion of the total value. The money is lent on the value of the property as collateral. As time progresses and the economy starts to recover and with more of an assurance of income, people are more willing to borrow and lenders are keener to lend. This availability of funds starts to drive up land values.

The banks, seeing land values rising, become ever keener to gain business by lending. This sets in train a positive feedback mechanism, with banks lending on the strength of land values - land values that seem as if they will go on rising for ever - that they have themselves created. It might be compared with a snake feeding on its own tail. In time, and it takes about fifteen years, the bubble swells, to the point that rates of return on property from rents are barely enough to cover the capital sums paid for those properties. Then the bubble bursts.

As the peak of the boom is approached and things are still looking good, it becomes difficult for any bank to avoid being sucked into the lending spree, as those that keep out become unattractive to investors, who look to the high shareholder value generated by the banks that are heading for trouble.

These land-based boom/bust cycles have been observable since around 18 year intervals from the beginning of the nineteenth century, apparently disrupted only by the world wars.

The solution is unpalatable - it is to replace, substantially, existing taxes with a tax on the rental value of land, as proposed here.

Were such a tax in place, land would be unappealing to investors and banks would not using it as collateral for loans. It would transform the banking system, as banks would have to adopt different criteria for lending, the most important of which was, not the value of any collateral, but the ability of the borrower to repay the loan. But until the temptation to lend for land purchase on the basis of land as collateral for the loan is removed, no amount of regulation and control will prevent these periodic crashes.