The new regulatory framework for banks: master piece, or unfinished symphony, or unresolvable puzzle?

By Freddy Van den Spiegel, Adjunct Professor, Vlerick Business School

Since the start of the crisis in 2007-2008, the banking sector has been hit by a tsunami of new regulations. Given the circumstances and the consequences of the crisis, this is not surprising, and a fundamental redesign of the regulatory framework seems justified in order to avoid similar catastrophes in the future. The problem of such redesign is however, that it is impossible to test the new framework, in order to understand its direct and indirect consequences, and the way it will change behavior. There exists no reliable laboratory that can check if the new rules will deliver what they are intended for. Finding the right balance of new regulations will therefore always be a question of guessing. That leads to a situation where there will always be analysts who will be convinced that new rules are overshooting, while others will claim that the reform is not going far enough.

What makes the situation even more complicated is that through history, crises have always been different. While there are some elements which can be considered as a common denominator of circumstances that increases the probability to a crisis, the crisis itself is only rarely the consequence of one isolated problem. It is most of the time a combination of several weaknesses that leads to a self-feeding chain reaction of panic which is out of control. And while it is most of the time possible to identify the trigger or triggers that started the crisis, the way the chain reaction functions is far more difficult to analyze and understand, let alone to predict.

The least we can do to assess the effectiveness of the new regulatory framework is to check if a crisis, similar to the one that started in 2007-2008, could happen again. While this looks like focusing on the last war, and not on the next one, it is at least a starting point.

For that analysis, we need a good view on all the elements that created the chain reaction. While economists disagree often about the exact trigger that started the downward process, there is a broad consensus about the elements of weaknesses in the system that facilitated the crisis process. In that respect, it is not important to agree for example if the crisis was started with the bursting of the housing bubble in the US, or with the complex and weakly designed securitization products like CDO’s. In fact all the elements interacted with each other and reinforced the financial meltdown.

Among the elements cited most as causes of the crisis are:

  • Weak and aggressive banks;
  • Unsustainable macro imbalances like housing bubbles or over indebtedness;
  • Weakness of the regulatory and supervisory framework to prevent and manage a crisis, especially in Europe;
  • Complexity, opaqueness and interconnectedness of the financial system.
  • The existence of systemic banks.

1. Weak and aggressive banks

Weak and aggressive banks have clearly been perceived as the true cause of the crisis. As a consequence, stricter micro prudential regulation has been in the center of the political debate. The crisis demonstrated that banks did not have enough capital to absorb the losses, that their sophisticated risk models were not able to identify adequately  the risks and that they had insufficient liquidity buffers to cope with problems in the short term funding markets. Most of these shortcomings have been corrected with the Basel III framework. Capital requirements increased, the definition of capital became narrower, the risk weightings, especially of the trading book were increased and liquidity buffers were introduced. While there is still room to discuss the exact calibration of the new rules,  this can only be welcomed: the integrated world economy has become more dangerous as a whole, and buffers have to increase. The Basel III review to a large extent can to a large extent be considered as an exercise to correct the obvious flaws in the Basel II framework. An interesting question to be asked is for example how it has been possible that a risk, held in the old fashioned banking book had a risk weight which was up to three times higher than the risk weight of that same position in the trading book. Why has that not from the start been identified as a tremendous incentive for banks to switch from their traditional activity to the more volatile market activity? And of course banks reacted exactly in line with the incentives built in the Basel II framework. They developed their market activities and considered the traditional banking activities as less appealing.  I am not asking this tricky question to put the blame for the developments in the banks in the camp of the supervisors, but it would be interesting to understand how these decisions have been taken, in order to avoid any similar mistakes in the future.

While some of the design errors of the Basel II framework have been corrected with Basel III, there are still others which are only tackled in a very indirect way. So for example, the fact that banks can develop their own models and calculate themselves the risks, on which their regulatory capital is based. While this seems at first sight an appropriate approach, as banks should be the best placed to understand their risks, it underestimates an important element, which is that banks are biased: they have a huge incentive to believe that risks are under control: lower risks means lower capital requirements, which improves the competitiveness of the bank. And as always in a strictly regulated sector, competition happens at the edge of regulation. In theory, there is a counterweight to the banks’ attitude in Basel II and III, through the Pillar II approach in which the supervisor can challenge the bank, but the supervisor will always be in a weak position in the debate with the banks, given their limited resources. Regulators are increasingly aware of this design problem. Bringing in the “leverage ratio” was the first tentative to water down the importance of models. But now, the EBA is investigating how it can be explained that banks have risk models which deliver very diverging risk assessments. Trying to converge the risk models of banks would almost get back to a “standardized approach” of risk measurement, which is exactly the opposite of the goals of Basel. A more straightforward approach is clearly necessary.

While Basel has indeed a direct impact on the balance sheet structure and profitability of banks, its impact on its ethics and governance remains unclear. It remains to be clarified how the boards will behave in the future. Concerning the past, it can only be observed that they did not play their role in having a long term view on the strategies of banks, and this despite the presence of so-called independent board members. The debate about the bonuses is linked to this broad problem of behavior and ethics, but can certainly not be considered to offer comprehensive answers to this fundamental problem.

2. Macro imbalances

It is very clear that macro imbalances played an important role in the crisis. Bubbles in the housing markets and over indebtedness of private or public households made the valuation of financial assets vulnerable and volatile.

As a result, macro prudential supervision or stability supervision is now considered to be an essential element of the safety net of the banking system. One could even compare it to a Copernican revolution. Before the crisis, the general consensus was that if each individual bank was safe, then the whole system would also be stable. In other words, the focus was on micro prudential supervision and a stable financial system was considered to be the automatic consequence of adequate micro prudential supervision. This vision has completely turned around. Having sound banks at the individual level does not guarantee that the financial system is stable. In other words, the most important goal of supervision is not the individual bank, but the stability of financial system. That requires that micro prudential supervision, monetary policy and other initiatives to protect financial stability now have to work together in order to maintain stability. This goes completely against the tendency in many countries to create supervisory authorities which were completely independent from the activities of central banks. The decision of the Eurozone to hand over banking supervision to the ECB is a clear example that such philosophy has completely changed. From now on, monetary policy and micro-prudential supervision are just instruments to protect financial stability.

Important challenges remain however. As a start, there is no clear definition of what financial stability is, which creates ambiguity and potentially chaos if the goal to achieve is not defined. Especially the European banking Union, which aims at a harmonized and integrated micro prudential approach, can be challenged, because macro prudential policy remains still essentially a national responsibility. Already now, we can see that member states take national macro prudential measures, using micro-prudential tools, for example in setting capital add-ons or in defining maximum loan to value for mortgage loans. While micro prudential supervision is completely harmonized, the stability supervision is not, which can lead once again to inconsistencies and contradictions in the banking rules, especially in difficult times.

3. Weak regulatory and supervisory framework

This brings me to the third element of weakness: the regulatory and supervisory framework. From the regulatory framework, as I said before, the new Basel rules will make the banking system more resilient. Also concerning supervision, the banking union in Europe will make supervision more harmonized and if the ECB is correctly playing its role, it will reduce the risk of forbearance and capture. But an essential condition is that the banking union is completely implemented, including not only single supervision, but also a funded European resolution mechanism and preferably a European Deposit Guarantee fund.

One of the most controversial elements of the new EU framework for crisis management is the bail in procedure by which most of the fund providers of banks would suffer losses, without formal bankruptcy of the bank. Such mechanism could prove to be extremely pro-cyclical when the situation of a bank starts to deteriorate.

At the global level however, far more has to be done to make sure that in times of crisis, coordinated intervention which does not create negative spillover effects in other countries is possible. The experience of the crisis has demonstrated that for example central banks are able to cooperate, be it with a certain delay which can be expensive. The crisis however gives also clear examples how policies which aim at stability in one country can create problems in other parts of the world. The QE policy of the Fed, and the debate about the timing of tapering, creating severe problems in a number of emerging economies demonstrates how difficult it can be to find solutions which are in national interests, without creating negative spillovers in the rest of the world.

4. Complexity, interconnectedness and opaqueness

Complexity, interconnectedness and opaqueness, all contribute to make it difficult to understand what is going on and to define what has to be done when something goes wrong. The collapse of the CDO market created a panic reaction because nobody could really assess their true risks and value. Banks were so complex that they did not immediately understand what their direct and indirect exposure to the problems was, leading to the freezing of the interbank market. The interconnectedness caused contagion of problems among banks.

One could have expected that the new regulatory framework would clearly identify these three characteristics as risky, with appropriate consequences in terms of capital requirements and other instruments to incentivize banks to become simpler. But this did not happen. Banking structures can still be extremely complex, consisting of thousands of legal entities, but all driven by a central executive committee of the holding company. Products remain as complex as before the crisis, and the Basel III rules have made risk management even more complex and opaque, despite an increasing number of supervisors, asking for more simple, straightforward rules.

Instruments to tackle complexity are in theory available, such as the resolution plans which banks have to prepare: excessive complexity will make a realistic resolution plan very difficult. But it remains to be seen if supervisors, assessing the proposed resolution plans will have the courage to use it as a key to force banks to simplify themselves.

5. Systemic banks

Probably the trickiest issue of the new framework is the treatment of systemic banks. At all levels, global, EU and national, a heated and confusing debate is going on. That the “too big to fail” problem should be resolved has full support, but the proposed instruments to get there are extremely divergent: forbidding big banks to exist, zero risk tolerance, capital add ons, the above mentioned resolution plans, or separating the market activity form the traditional retail activity are all proposed. As none of these proposals gets full support, the outcome is a strange mix of resolution plans in which the supervisors do not seem to believe, capital add ons which are not really tackling the problem, and a split while everybody seems to understand that also narrow banks need access to capital markets but nobody knows how to define these exactly.

Given the importance of these systemic banks, certainly in EU, this chaotic and never ending debate is dangerous.

6. Some conclusions

The answer to the initial question: is the new regulatory framework a master piece, an unfinished symphony or an unresolvable puzzle is probably that it is all of this. It is an unfinished symphony, but that could also be a master piece in itself as the unfinished symphony of Schubert illustrates. But even more, it is a puzzle where the “perfect” solution is not available. Creating a framework for guaranteed stable banks has never been achieved and will remain out of reach, as any regulatory framework leads to changing behavior, and to competition which is always at the edge of what is allowed.

Continuous alertness is therefore probably the best protection against a crisis. It is always when people collectively believe that risks are under control, for example like in the decade before this crisis, characterized by the “great moderation”, that operators become overconfident, which in itself is the starting point that undermines any firewall against crisis, no matter how thick it is.

In that sense, the actual awareness that the world is full of risk is perhaps the best protection against a coming crisis, as long as that attitude is not leading to deep pessimism. To put it in the words of Keynes: But let me end with a quote of Keynes (1931): “If we consistently act on the optimistic hypothesis, this hypothesis will tend to be realized; whilst by acting on the pessimistic hypothesis we can keep ourselves for ever in the pit of want”. So, we have no choice but to be optimistic.

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