Reference no: EM13147087

 Read the following article and answer the questions at the end.

"Basel gives central banks power they really need" by Ian Verrender

RESERVE bank governor Glenn Stevens has raised the spectre of yet another interest rate rise.

That shouldn't come as any great surprise. With mineral exports booming and rural commodities acting in sync for the first time in living memory, our economy is facing a massive inflow of cash from overseas.

That's one of the reasons the Australian dollar is so strong. That and the fact that leaders in the developed world - other than our own Julia Gillard - are devising more fiendish means to push their currencies lower while maintaining interest rates at just above zero in a desperate attempt to revitalise their economies.

 But as Stevens delicately attempted to explain the finer points of monetary policy - and specifically the blunt axe of interest rates - to an audience in Shepparton yesterday, a quiet revolution has been proposed in the way central bankers run economies.

One of the least reported and least understood recommendations to emerge from the gathering of bankers in Basel, Switzerland, last week is a measure that will enhance central banks' power to control their economies.

For most of the past year, bankers and their well-resourced lobbyists have spread fear through the developed world, saying any regulations restricting lending will inevitably lead to lower economic growth, to the detriment of everyone.

The new regulations - insisting that banks have far greater reserves to cope with the kind of economic meltdown seen in the past couple of years - were not as bad as some had feared.

When fully implemented in 2019, banks will be forced to hold 7 per cent of their equity in reserve, to act as a buffer if a global crash puts them in peril. That is way above the current requirement to hold just 2 per cent of equity.

But an optional third measure has been adopted. This enables central banks to impose greater restrictions on lending during boom times, forcing banks to set aside up to a further 2.5 per cent of their equity. It is this measure that makes enormous sense and potentially gives regulators greater power in curbing asset price bubbles, providing them with another tool to regulate the economy.

Under this option, regulators can force banks to put more of their capital aside at the time they can most easily afford it, but at the very time most would be recklessly chasing market share by lending even more, fuelling asset price bubbles.

Until now, central banks have been primarily concerned with inflation. The thinking has been: keep inflation under control and prosperity eventually will follow. Push interest rates higher when the economy is strengthening, ease off when it cools.

That works fine when things are ticking along nicely.

Unfortunately, when the global economy was perched on the edge of the abyss in late 2008, no amount of interest rate cuts seemed to work. Even now, unemployment in the US is sitting near an uncomfortably high 10 per cent and Japan shows no sign of recovery.

As a result, central banks have come under attack for allowing the sharemarket booms and the property bubbles that have wreaked so much havoc. Why couldn't they see what was happening in US real estate? How could they not have known that Wall Street's investment banks were dropping fuel on a raging firestorm?

The answer is that the US Federal Reserve and central bankers in Europe were fully aware of what was happening but chose to let markets behave the way markets do.

They've always believed that it is not their role to interfere and that those engaging in reckless behaviour should suffer the consequences.

Not anymore. They've now learnt that catastrophic market collapses can affect not just rich investors, but the broader economy.

Hence the new tools. By restricting lending during an obvious boom, central banks may be able to moderate asset price bubbles in share, bond or property markets.

 At the moment, banks tend to cut back on their lending during market downturns, when they are desperately attempting to restore their damaged balance sheets. That has the effect of deepening a recession.

The idea behind the new Basel III recommendations is that money hoarded during the boom can then be released during a recession.

Will these new measures ensure we never see a repeat of the past few years? Absolutely not. There will be another crash. Most of us won't see it coming. But every major market crash in the past three decades has been preceded by reckless lending on the part of the world's biggest banks.

The big question, though, is that if highly paid commercial bankers can get it so wrong so often, can we trust bureaucratic central bankers to keep them in line?

Questions

1.Why would banks tend to lend more in booms and less in downturns?

2.What do these proposals mean for the RBA's policy of targeting inflation?