Last night, the top financial regulator in the U.K., Adair Turner, delivered an address that upends conventional wisdom about new bank capital standards. Siding with big banks, Lord Turner suggested that higher capital rules could in fact reduce lending and, thus, make still worse the ongoing macroeconomic malaise. Music to big banks’ ears, of course. But, that’s not all Lord Turner suggested. Before big banks start to dance, they should read on. Lord Turner says that perhaps the only way to ensure banks fulfill their fundamental function – credit intermediation – is for regulation to force this upon them.

Lord Turner states that giving banks capital relief would not necessarily enhance credit availability – as banks promise – because stressed as they are, banks could use this relief only as an incentive to take on still more risk. In fact, with or without still higher capital, Lord Turner thinks big banks could pose undue risk because they would still be left too much on the loose. His solution:

“We may need to consider prudential tools which lean far more aggressively than in the past against the proliferation of intra-financial system complexity, the use of balance sheets to support inter-bank position-taking … And we may have to consider using macro-prudential levers which apply at the level of ring-fenced banks …focused solely on core services to the real economy.”

What does this mean when translated from the macro-terminology favored by regulators to the hard turf of new rules? A we read it, it’s a suggestion that big banks need to be told what to do in no uncertain terms – the “narrow-bank” mandate long favored by President Obama’s new nominee to the FDIC, Tom Hoenig. Lord Turner is suggesting that capital relief may be warranted to get the economy going, but only if doing so doesn’t raise new macroprudential risks. These would come, he fears, because big banks out from under the capital gun

would remain so big, so inter-connected and so committed to non-bank activities that lower capital wouldn’t do much beyond starting the leverage time-bomb ticking all over again.

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