Andy Haldane's regulatory reform litmus test: would it be used to wage a financial crisis war

In a Telegraph article about bail-in bonds (a form of contingent convertible debt that absorbs losses after shareholders are wiped out), the Bank of England's Andy Haldane lays out the litmus test for all financial regulatory reform.

Having debtors assume pain is fine on paper. But crisis wars are not waged on paper. 

Debt instruments which had bail-in style properties in the 2008 meltdown were not triggered, he pointed out, "because [bank management] feared scaring creditors and making a bad situation worse". 

Policy by regulators has been no different, he said, adding: "Pre-crisis, deposit and liquidity insurance were enshrined in a well-defined regime. But in the teeth of crisis, these regimes were abandoned."

His litmus test for any regulatory reform is not does it look fine on paper, but rather would regulators actually use it to fight a financial crisis.

What a great litmus test! [Full disclosure, your humble blogger happens to think very highly of Mr. Haldane and his work.]

To see how this litmus test works, let's apply it to bank capital.  The theory behind bank capital is that it is there to absorb losses.

As a result, a significant amount of regulatory time and energy since the beginning of the solvency crisis has gone into crafting the Basel III capital rules including the requirement that systemically important financial institutions carry an additional capital buffer.

As Mr. Haldane would say, all of that is fine on paper.  The litmus test is would financial regulators actually use bank capital to fight a financial crisis.

Unfortunately, history shows that just like the well-defined pre-crisis deposit and liquidity insurance regime, using bank capital to absorb losses was also abandoned in the teeth of the crisis.

Bank capital is not the only area where regulatory reform fails Mr. Haldane's litmus test.  I invite readers to comment on additional reforms, virtually all of the Dodd-Frank Act is fair game, that look fine on paper, but will do nothing to help in the battle against the next financial crisis.