Banking reform: A New Year’s resolution

When G20 regulators met in Pittsburgh in September 2009–it had taken them a full year to react to the collapse of Lehman Brothers–they set out an ambitious financial reform agenda. No stone would be left unturned, no shadow in the banking system unexposed. Action would cover all financial market segments and players, and lessons would be learned from the crisis to ensure that the 2008 debacle never happened again.

A body called the Financial Stability Board was tasked with coordinating these gargantuan efforts at change and drawing a detailed list of reforms on which global and national regulators should eventually deliver.

As 2014 dawns, have those reforms made progress? Was the wish list just a letter to Santa Claus, or have real gifts in the form of better, healthier banks been delivered to expectant citizens?

The first place to look is the set of reforms known as Basel III, the third generation of global rules put forward by the Basel Committee on Banking Supervision in response to the current global financial crisis (it was the 1980s Latin American debt crisis that led to the first Basel Capital Accord in 1988). The rules will force banks to increase their capital and liquidity requirements by 2019. So far implementation appears to be progressing well.

Banks have been pre-empting these stricter requirements by beefing up their capital ratios, deemed too weak to withstand future crises. However, a closer look shows that many banks have strengthened their ratios at the expense of reduced lending. This is “bad deleveraging” since it shrinks balance sheets, instead of raising new capital.

Not that higher regulatory capital is enough to make the financial sector stronger or more resilient to shocks. The reforms do not adequately address the real culprits in this crisis, particularly the problem of too-big-to-fail institutions and their interconnectedness, especially via exposure to derivatives (what billionaire investor Warren Buffet famously likened to “weapons of mass destruction”).

Banks need little capital in calm periods, but in a crisis they cannot have enough. There is no reasonable capital rule to help large, systemically important financial institutions that will make them safe. Separation of risky investment banking from high street retail banking could deal with this problem. And because these firms operate across borders, a unified or coordinated approach would help avoid the kind of regulatory arbitrage that was so pertinent in the build-up of this crisis. Regulators are still discussing reforms in the EU, based on the Liikanen report proposals. Will they opt for the right approach?

We suggest a ring-fenced non-operating holding company (NOHC) structure. And the threshold measure for when to break up a bank should be based on how much it holds in derivatives relative to other assets.

Back to Basel. Capital requirements based on a simple leverage ratio, using total instead of complex, risk-weighted assets, could go a long way towards improving banks’ capital bases. Let’s remember that Dexia, the failed Belgian bank, complied with regulatory capital requirements before it collapsed, but these were too intricate. A look at a simple leverage ratio would have shown just how far off the safety mark Dexia was. Banks may complain that this would be costly and make them lend less, but we would argue (and have shown empirically) that safer banks make for better lending. This is in line with an approach that US regulators took in July 2013 when they proposed a rule to strengthen the leverage ratio standards for the largest, most systemically significant US banking organisations that goes beyond reforms currently proposed under Basel III, with leverage ratio requirements up to 6%. US regulators are also proposing to top up the Basel liquidity rules.

US authorities also had a stronger hand on their banks at the beginning of the crisis, when resolute stress tests were followed by a decisive clean-up of banks’ balance sheets with government involvement where necessary. Regulators also reacted quickly when casting reforms into the Dodd-Frank Act that was signed into law in July 2010. However, the act is overly long and complex, causing delays and allowing lobby groups to pull the teeth out of some follow-up legislation. As of 2 December 2013, only 165 of the 398 total required rule-makings had been finalised, and a further 111 have not even been proposed yet.

While the Volcker rule of bank separation– seen by many as the centrepiece of the Dodd-Frank reforms–was finally approved on 10 December 2013 (to come into effect in July 2015), it remains to be seen how it works in practice. To be sure, it will keep many bank lawyers active who will try to find loopholes or even bring lawsuits against the regulators.

While the OECD has been emphasising that getting it right is more important than speed in financial reforms, there is now a danger that the reform progress will come to a halt as reform fatigue, reinforced by lobbying activities, takes hold of regulators as well as the regulated.

Europe’s banking union In Europe, reform dynamics may be similar but the situation is structurally different. European economies are about three-quarters bank financed, whereas in the US the share is about a quarter, which is one reason why the OECD also supports efforts to promote non-bank finance alternatives in particular to finance European small and medium-sized enterprises (SMEs). EU banks’ balance sheets are also weaker than those of their US counterparts (see graph). At the same time, Europe’s banks tend to be larger and systemically more important at the domestic and international levels. This makes them not only too big to fail, but often also too big to be bailed out by a single government or central bank.

Click to enlarge.

Serious attention must therefore now be given to the outcomes of the 2014 health checks of the euro area banking sector. After all, euro area banks still have considerable bad assets that need to be recognised and written off. The Asset Quality Review and stress tests must be implemented rigorously, and followed up by bank recapitalisation or restructuring where needed. And further progress must be made on establishing a fully fledged banking union. The agreement reached by EU finance ministers on 18 December 2013 to set up a common backstop for failing banks–a crucial element of the “single resolution mechanism”–is an important step forward. While an EU banking union is not a panacea for the current crisis, it will help to strengthen the banking system and, in time, sever those detrimental linkages banks have to their own government’s debt.

In short, with the crisis still biting, the New Year’s resolution for regulators in 2014 should be to reform the banking sector properly, and help rebuild the trust our economies so badly need.

References

BCBS (2011), Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, revised version, June.

Blundell-Wignall, Adrian et al. (2013), “Bank business models and the separation issue”, in OECD Journal: Financial Market Trends Vol. 2013/2

European Commission (2013), A New Financial System for Europe, EC Internal Market and Services

ICB (2011), Final Report: Recommendations (“Vickers Report”): London.

Liikanen, Erkki (2012), High-Level Expert Group on Reforming the Structure of the EU Banking Sector: Final Report: Brussels 

Wehinger, Gert (2013), “Banking, ethics and good principles” in OECD Observer, No 294, Q1.

US Congress (2010), Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R. 4173)

©OECD Observer No 297, Q4 2013




Economic data

GDP : +0.5%, Q4 2014
Employment rate: 65.9%, Q4 2014
Annual inflation : 0.57% Feb 2015
Trade : -3.0% exp, -3.7 imp, Q4 2014
Unemployment : 7.022% Feb 2015
More moderate expansion ahead? Composite leading indicators
Updated: 23 Apr 2015

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