Regulation red herring

Eamonn Butler claims that regulation is killing banks:

Far from making things safer for bank customers, [Basle II] pushed banks to the brink of ruin.
When the banks discovered that their “assets” were riddled with junk, everyone ran scared. Nobody knew exactly how “toxic” it all was, so the banks couldn't unload it on to anyone. Their “assets” became worthless. Under the Basle rules, they had to stop lending. Hello, credit crunch….Banks are largely solvent - it's regulation that threatens to bankrupt them.

I’m not convinced. If banks operated in a free market, they would also have had to stop lending as their assets became worthless. This is because, as Jackart says, in a free market - where deposits were not guaranteed by the state - banks would have to maintain a high capital-assets ratio in order to persuade depositors that their money was safe. Write-offs of risky assets, which reduced their capital base, would therefore have as deleterious effect upon lending in a free market as they would under Basle II - maybe more so.
You could try and rescue Mr Butler’s story by arguing that in a free market banks wouldn’t have held “toxic assets” in the first place - even though they were (titter ye not) AAA-rated. Or perhaps their capital ratios would have been so much bigger that they could cope with write-offs.  Or something else.
Such stories, however, run into a problem - the facts. As Carmen Reinhardt and Ken Rogoff point out (pdf), banking crises have been frequent around the world since at least the industrial revolution. They happen under  free markets as well as under regulated ones.
So, why don’t we just recognize that the issue of free markets vs. regulation is, in this context, a red herring? And to claim that the crisis wouldn't have happened in a free market is just silly utopianism.
Bank crises happen for the same reasons that government fails - because all organizations face problems of limited knowledge, bounded rationality and inadequately designed incentives.

Comments

[Jonathan]

'Bank crises happen for the same reasons that government fails - because all organizations face problems of limited knowledge, bounded rational and inadequately designed incentives'
Agreed but with a libertarian bent. I strongly recommend a recent book by Hulsmann http://mises.org/books/moneyproduction.pdf
If money lent represented foregone consumption by another, (mad idea in a fractional reserve banking world), we could not have bank runs en masse.

[kinglear]

... and greed....

[Blissex]

From a debate in 1997, a debate that says it all:

http://www.derivativesstrategy.com/magazine/archive/1997/0597rtbl.asp
http://www.derivativesstrategy.com/magazine/archive/1997/0597qa.asp

This fantastic quote about the perils of the USA imitating UK self regulation (it happened of course thanks to prof. Gramm):

«Avoid the British experience. As the professional market legislation also proposes, U.K. regulators concentrated on the politically correct goal of protecting small punters, leaving professionals to their own devices. Knowing the relevant history, a U.S. politician worth his or her salt should wonder if the Conservative government's approach to market oversight has something to do with the number of Tory resumes on the street, and if a vote to duplicate U.K. market regulation communicates this disease, brought on by a rapid succession of Barings, Morgan Grenfell and Sumitomo problems, to name a few. British regulation, now recovering and making adjustments, failed not only to protect the public from the industry, but the industry from itself. Not a good idea in the United States.»

[Andrew Duffin]

"If banks operated in a free market, they would also have had to stop lending as their assets became worthless."

Well yes, but that is exactly what Dr. Butler thinks should happen, so it is not exactly a problem with his argument.

You might argue that the consequences of that would be even worse than what we have now, but you didn't make that argument, so I am not going to tilt at the strawman.