Have regulators deepened the recession?

Talking of the possible need for even more unconventional economic policies (as Adair Turner has been doing), to ward off the risk of the UK economy turning Japanese and stagnating for decades, something pretty odd and unconventional has been happening in the regulation of banks, for just that reason.

In the last few weeks, the soon-to-be-disbanded Financial Services Authority has told banks that any extra lending they make to the UK economy - to businesses and households - can be provided without incurring any additional capital charge. Which in theory should significantly reduce the costs for banks of lending.

And the FSA is also allowing banks to hold a much wider and more diverse and riskier collection of supposedly liquid investments, as a proxy for cash, which is their rainy-day money in case too many of their depositors want their cash back at the same time (it is the insurance against bank runs).

That also represents a significant cut for banks in the cost for them of doing business, because the safest liquid investments - such as government bonds - pay the lowest income.

A bit of translation may be in order.

As you know, banks have to hold capital to absorb potential losses when they lend. And one of the big causes of the great crash of 2007-8 is that over 30 years - due in part to appalling regulation - banks were allowed to reduce their capital reserves to a tiny fraction of their massive loans and investments.

Which is why when the bust came, taxpayers and not just shareholders incurred massive costs, bailing out the banking system.

So in a huge global financial manifestation of an enormous barn door being closed long after all the horses have vanished from sight, banks since 2008 have been forced by regulators all over the world to hold more capital, relative to the loans and investments they make.

Many would say closing that barn door was inevitable and rational. The British government's finances, for one, could not withstand another calamity on the scale of what we have just suffered.

But capital is expensive for banks to raise - because it is the money that is (in theory) most in danger of being lost when times are hard.

So banks have an incentive to keep to a minimum their ratios of capital to loans (or assets). And when they are ordered to boost their capital ratios, there is the paradoxical consequence that they will tend to lend less - which in turn leads to an economic slowdown, which in turn means that their customers have more difficulty repaying their debts, which in turn weakens banks.

So we find ourselves - as Lord Turner more or less admitted last night - trapped in a nightmare where trying to do the right thing to strengthen banks has the paradoxical and wrong outcome of undermining economic recovery and further debilitating the banks.

Or to use the dreadful jargon, forcing banks to hold more capital can accelerate the process of deleveraging (paying off debts). Deleveraging is necessary after a borrowing binge of the sort that took place in the UK, US and much of western Europe in the years before the crash, but it can savagely undermine prosperity if it happens too fast.

Anyway it may well be many years before we have a clear view of whether the regulators who permitted banks to hold far too little capital during the boom have subsequently moved too fast or too slowly in forcing them to raise more capital subsequently.

What's fascinating is that the FSA has more or less admitted that it thinks that it may have been too zealous in the way it forced banks to build their capital reserves - or at least it has in a way, because the banks would say (in fact they do say) that the FSA is still facing in two directions.

Brief interlude: I should point out that the FSA is not the independent boss of its own actions any longer. It is being wound up, and the relevant bit of it for our purposes is merging with the Bank of England; and right now the FSA is acting under de facto instruction from the Bank of England's "interim" Financial Policy Committee (FPC), which next year will become the formal boss of all this prudential stuff when it is given statutory authority.

Here is the thing.

With the encouragement of the FPC, the FSA has (as I've mentioned) told banks that if they make incremental loans to British businesses and households as measured by the Bank of England, they can do so by running down the buffers of capital they have built up (or to put it another way, they don't have to raise any new capital for this lending).

Now some have characterised this as the banks being able to lend under the Bank of England's new Funding for Lending Scheme, free of capital charge. But that is incorrect. Because HSBC, which is not taking advantage of Funding for Lending, can also lend incrementally without setting aside extra capital.

The important point, to repeat, is that this should make it cheaper and easier for the banks to lend.

Except for one thing.

The FPC has also said that it wants banks to become more resilient by building up even more capital, particularly because it believes there is a serious danger of the eurozone dissolving in a chaotic way that would wreak havoc for banks.

"You what?" you might be tempted to exclaim. "What on earth is going on? How can the FPC and the FSA say - on the one hand - that banks can reduce their capital ratios by lending more to the British economy and simultaneously say that banks have to become more resilient by holding even more capital and liquid assets?"

This may be one of those rare occasions where, however unfashionable it may be, it is possible to feel a degree of sympathy for bankers, because they may feel the regulators who boss them around are sending them somewhat confusing signals.

As you would expect, I have asked the regulators what drugs they are taking. And here is their answer.

First, that there is a timing issue here. They will be more lenient on capital ratios while the economy is particularly anaemic, as it is now, but in the longer term they would expect banks to take further steps to rebuild capital.

Second, there is an issue of priorities for the banks. The regulators will indulge banks that want to reduce capital ratios by lending more, but not banks that wish to eat into capital resources by paying big bonuses or dividends.

Third, and this made me smile, they accept that they may have presented these conflicting messages in a manner that is not as clear as they might have liked.

So there we have it.

Banks can hold less capital today and must hold more again tomorrow. Which may represent better news for those who want to borrow from them.

But it's bloomin' awful for bank shareholders and bank executives - because it means dividends and bonuses will remain under intense downward pressure (don't dchuckle, that's really unworthy).