[vc_row][vc_column css=”.vc_custom_1440853933261{background-color: #e0e0e0 !important;}”][vc_column_text css=”.vc_custom_1466174437209{margin-top: 15px !important;margin-right: 10px !important;margin-bottom: 15px !important;margin-left: 10px !important;}”]The great financial crisis revealed vulnerabilities of the regulated banking system’s capital structure, liquidity reserves and resolution regimes. This has given rise to an unprecedented expansion and tightening of regulatory rules that include a massive increase in minimum capital ratios, mandatory minimum leverage ratios, new compulsory liquidity ratios and new resolution regimes. The new rules may have unintended consequences, however, including tighter bank lending conditions and more regulatory arbitrage.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][vc_empty_space height=”24px”][vc_column_text]

The regulated banking system

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Leverage, expansion and regulation

From the early 1890s to the 1970s the average bank credit-to-GDP ratio in the developed world was stationary, hovering around 50%. Thereafter, however, bank lending soared, alongside deregulation and a decline in interest rates, and reached 114% by 2010 (view post here). The expansion of regulated banking supported macro trading strategies through the provision of funding and market liquidity, the monitoring of creditworthiness of a large part of the economy, and payment and settlement services.

Regulated banks are highly leveraged institutions: their average ratio of debt to equity has been roughly 19:1, compared with roughly 1:1 for large non-financial companies. At the same their functioning is critical for modern economies. Individual banking crises in the past have on average entailed losses of almost 100% of an annual GDP overtime (view post here).

As a consequence public supervision and capital regulation have long been essential parts of modern banking systems. However, the great financial crisis of 2008 revealed important shortcomings of that regulation, particularly in respect to (a) capital adequacy, (b) liquidity management, and (c) moral hazard in the risk management of large systemic banks. This has motivated an unprecedented expansion of regulatory restrictions on the banking system in the 2010s, which has affected both macroeconomic trends and structural features of markets. Also, greater complexity and policymaker discretion in regulatory policies means that investment managers must pay more attention to them, not unlike the way they follow monetary policies (view post here).[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“Banking, is a service like healthcare, in which ‘transactions’ take place between two parties that differ in terms of information, knowledge and technical competence”

Sabine Lautenschläger, Member of the Executive Board of the ECB, September 2015.[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

Capital regulation

Strengthening the quantity and quality of capital held by banks has been a central element of post-financial crisis regulatory reform. Specifically, there have been three complementary threads of reform:

[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“Pre-crisis, the global regulatory framework was based on a single metric – the risk-weighted capital ratio. Today’s global framework is strikingly different to the one we had in place prior to the crisis as it is based on multiple metrics rather than a single one.”

Stefan Ingves, Chairman of the Basel Committee on Banking Supervision, October 2015[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

Drawbacks of tighter capital regulation

The intention of tighter capital regulation is to foster a more stable financial system.  Indeed, BIS research estimates that the benefits of tighter capital regulation in terms of long-term growth would significantly outstrip costs (view post here). However, there are also risks of unintended and adverse consequences:

[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“New regulations may lead to shifts in the institutional location of particular financial activities, which can potentially offset the expected effects of the regulatory reforms.”

Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System, October 2015[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

Bank failure and resolution

Banking system reform also aims at credible resolution mechanisms for failing banks, particularly those of global and systemic importance. Credible here means that in case of impending default the home authorities would choose resolution over “bailout”. The objective is to be able to resolve any large institution regardless of its home jurisdiction without taxpayer funds and in a way that prevents serious systemic repercussions.

Potential bank failure and resolution are a particular challenge in the euro area. On the one hand, monetary policy is centralized and regional financial integration very deep. On the other hand, fiscal policy and banking regulation have remained fragmented along national borders. In the early 2010s this fragmentation gave rise to so-called “doom loops”, the concurrent and reinforcing weakening of national public finances and national banking systems. The area-wide stability of banking thus can be impaired by national economic and financial developments.

The euro area sovereign and banking crises have given rise to integration, such as a direct recapitalization by the European Stability Mechanism and EU bank recovery and resolution rules (view post here). The main pillars of an institutionalized European banking union have been introduced in 2014/15 and focus on the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM), but fall short of an area-wide deposit insurance and reliable and sufficient resolution funds (view post here).[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“A resolution action taken in anticipation of an otherwise unavoidable liquidation of a credit institution should not imply a general bail-out of that bank’s creditors.”

Fernando Restoy, Deputy Governor of the Bank of Spain, June 2014[/vc_message][/vc_column][/vc_row][vc_row][vc_column width=”2/3″][vc_column_text]

Liquidity regulation

Another key area of regulatory reform are rules for the transformation of liquidity and maturity risk (view post here). Liquidity regulation is motivated by past funding crises and a fundamental moral hazard: financial institutions might hold insufficient liquidity buffers because they disregard the social cost of systemic crises and count on emergency support. Four major regulatory changes have been introduced in recent years. All of them have side effects.

[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_empty_space][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“Liquidity mismatches and the over-reliance on wholesale funding were at the core of failures and rescues in the recent crisis.”

Jean Tirole, Professor of Economics and Nobel Memorial Prize Winner, 2010[/vc_message][vc_message message_box_style=”solid-icon” message_box_color=”grey” icon_fontawesome=”fa fa-comment-o”]“Minimum quantitative liquidity requirements have been developed in the form of the shorter-horizon Liquidity Coverage Ratio (LCR) and the longer-horizon Net Stable Funding Ratio, which together are intended to place some limits on excessive reliance on runnable liabilities.”

Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, September 2015[/vc_message][/vc_column][/vc_row]

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