Illustration by David Simonds

BANKERS have a bad habit of making economic cycles worse. They are notorious for lending people umbrellas when the sun is shining and asking for them back when rain starts to fall. When the economy is strong and asset prices are rising, banks are only too eager to lend to those wanting to buy assets, helping to push prices higher. In bad times, when prices are falling, banks ask for their loans back, forcing the borrowers to sell assets and driving prices down further.

Right now, banks are desperately plastering over the cracks in their balance sheets created by the credit crunch. This week Royal Bank of Scotland launched a £12 billion ($24 billion) rights issue ( see article). Other banks have tapped the bulging wallets of sovereign wealth funds. But there may be a limit to investors' largesse: those who have bailed out banks so far have lost money.

If the well of investors' patience does run dry and banks are forced to shrink their lending, the economic situation may get a lot worse. Already the riskiest borrowers in America and Britain are being shut out of mortgage markets, with predictable consequences for house prices.

Regulators are partly to blame. When the credit boom was roaring in 2005 and 2006, central banks did make pointed comments about the “underpricing of risk”—in plain English, that banks were not charging borrowers enough. But they did nothing about it; indeed, by keeping nominal interest rates low, they encouraged the credit excesses.

International regulations on the capital adequacy of banks do exist, but they tend to be procyclical too, requiring lenders to raise more capital only when the problems have already occurred. And the regulators tend to be one step behind the practitioners. Banks were able to exploit the first lot of so-called Basel rules, because they could hide risky loans off their balance sheets. The new rules, Basel 2, may be more sophisticated in their treatment of risk but they rely heavily on models developed by banks themselves. As the past year's events have demonstrated, those models can be seriously flawed.

Cycling backwards

Could there be a better way to regulate the industry? The regulations could be countercyclical, requiring banks to be like the biblical Joseph and raise more money in the fat years to see them through the lean ones. Defining the cycle may sound prohibitively difficult but Charles Goodhart, a professor at the London School of Economics (and a former monetary policymaker at the Bank of England), suggests a way around it: monitoring whether the pace of loan growth or the rate of increase of asset prices was moving sharply above trend, and requiring banks to find more capital if the alarm sounds. Had such a rule been in place, the subprime-mortgage boom might not have been so explosive.

Of course, the devil would be in the detail. Regulators would need a breakdown of how bank lending was being directed to different geographical areas and asset classes. In good times, greedy bankers would have the incentive to cheat; for example, by making loans to offshore holding companies that would then pass on the money to Florida condo-buyers. Such rules would need to be international, to stop foreign banks from stealing market share from banks in countries that observed the regulations.

The regulators would also need to be careful about being too lax during the downturns. After all, it is at such times that banks are most likely to need capital to keep them afloat. Bank customers might be resentful if they felt regulators had been complicit in letting a bank go under (although deposit insurance should soothe them). But if banks are forced to raise more capital during the booms, their finances should be stronger during the busts.

Despite this, countercyclical regulations would not be popular with the bankers. Over a full cycle, such rules would probably require banks to have more capital than under the existing system (and given the rescue of Bear Stearns, the rules would need to apply to investment as well as commercial banks). Because money tied up in capital earns lower returns, that would mean lower profits.

But it is hard to feel much sympathy for bankers who rake in fortunes during the boom and require taxpayers to help them out in the bust (or make central banks jump through hoops for them, as the Bank of England has done this week—see article). An efficient financial sector is vital for a modern economy but trading securities has arguably achieved too much importance in the Anglo-Saxon world. Winston Churchill once said that he would rather see finance less proud and industry more content. That is not a bad motto for those devising a new set of banking regulations.