Banking regulatory reform: The way forward

Xavier Vives 06 December 2016

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The financial crisis of 2007-09 revealed massive market and regulatory failure (Baily et al. 2013, Brunnermeier et al. 2009). This triggered reforms of both formal regulations and the institutions that implement them, but are these reforms built on a solid foundation?

Following the systemic financial crises in the 20th century, culminating in the great crisis of 2007-09, we may wonder if we will ever learn how to avoid them (Reinhart and Rogoff 2009). In the US, from the panic of 1907, through the collapse of the S&L industry in the 1980s, and most recently the Subprime Crisis, we have witnessed how shadow banks threaten the regular banking system and foster deregulation. The regulatory system established after the Great Depression of the 1930s was based on introducing deposit insurance and controlling moral hazard through the separation of investment and commercial banking activities (The Glass-Steagall Act of 1933). It also created strict regulation, including of interest rates that banks paid on deposits (regulation Q, enacted in 1933). Money market mutual funds destabilised banks, and by 1986 regulation Q’s restrictions on rates were phased out. S&Ls could then extend the range of their activities and assume more risk without tightening solvency requirements.

We have seen cycles of lax regulation followed by crises, in turn followed by periods of strict regulation. The latest example is the relaxation of regulation before the subprime crisis and current regulatory tightening. Why did regulation fail, what does regulatory reform seek to accomplish, and will it succeed? In a new book, I provide some answers (Vives 2016).

Regulatory failure before the crisis

Regulation became lax in the years before the subprime crisis. Capital ratios as a percentage of assets for banks declined, as well as liquidity buffers. The risk-based approach to capital requirements, and the use of internal capital models by banks, proved ineffective due to their complexity and the possibility that they could be gamed. The result was a low quantity, and quality, of capital. There was regulatory arbitrage between the sector of depository institutions – which was regulated – and the parallel shadow banking system of structured investment vehicles, which was far less so. Market discipline was ineffective because of the blanket insurance provided by too-big-to-fail (TBTF) policies. Financial sector lobbying succeeded in lifting asset restrictions. The crisis later showed that the capacity of modern banking to leverage the insured deposit base in high-risk trading bets gave financial institutions excessive incentives to assume risk.

Prudential regulation did not properly take macroprudential concerns into account. The lack of attention before the crisis to liquidity requirements led to diminishing liquid assets in bank balances. Banks had no cushion to limit asset sales when they needed cash, and hence contributed to systemic risk. The absence of appropriate liquidity requirements combined with the effects of increased disclosure and powerful public signals that could rally expectations on a run equilibrium – such as the family of ABX credit derivative indexes on subprime mortgages – to increase systemic risk (Vives 2014).

Finally, there were inadequate resolution procedures and tools, which increased the cost of restructuring and liquidation. This pushed authorities to create blanket bailouts or even not to intervene at all, as with Lehman Brothers. Competition policy also conflicted with stability measures such as mergers and state aid to the banking industry, which may have distorted competition and aggravated the TBTF problem.

Regulatory reform

Regulatory reform (according to Basel III) has focused on macroprudential regulation. The objective was to counteract the external effects of bank behaviour that impact systemic risk. These regulations have a cross-section dimension to address interconnectedness and contagion, as well as a times-series dimension to reduce fluctuations and volatility in the credit cycle and prevent the build-up of systemic risk.

In the US, restrictions to separate commercial and investment banking activities have been implemented with the Dodd-Frank Act of 2010, which includes the Volcker rule to prohibit proprietary trading by banks on their own account. The UK has introduced similar restrictions, ring-fencing retail activities in universal banks, whereas the EU has proposed the Liikanen recommendations to achieve the same end. Regulatory reform has emphasised resolution. In 2011 the G20 endorsed the Financial Stability Board (FSB) Key Attributes framework, designed “to resolve failing financial firms in an orderly manner, by protecting critical functions and without exposing the taxpayer to the risk of loss”.

Assessment of regulatory reform

Given that regulatory reforms are headed in the right direction  we can still question whether they go far enough, whether they will be effective, and whether they are consistent. There is consensus on the need for higher quality and quantity of capital, avoiding procyclical regulation, but there is debate over what the adequate level of capital for banking firms would be. The current regulatory framework, disclosure rules, and reform proposals do not contemplate the interaction between capital and liquidity requirements, even though capital and liquidity requirements are partially substitutable and disclosure requirements should not be established independently of liquidity requirements. Evidence for this is the role of the ABX indexes in the most recent crisis, which coordinated expectations in the run on the shadow banking system.

Regulatory reform addresses the TBTF problem based on the recommendations of the FSB and the Basel Committee on Banking Supervision. This means higher capital and insurance charges for SIFIs, control of remuneration, effective resolution procedures, and activity restrictions according to the bank structure reform measures.

But the calibration of systemic surcharges for SIFIs, and the effectiveness of their resolution procedures, have yet to be tested. The limits on executive compensation do not link executive remuneration to the welfare of bank creditors or the role of the entity in contributing toward systemic risk, and so do not directly address the incentive to assume too much risk that is implicit in banks’ corporate charters. Mandatory central clearing of OTC derivative markets may be a step in the right direction, but this centralisation may make the central clearing counterparties (CCPs) too big to fail, and the resolution procedures of systemic CCPs are not yet in place.

Structural banking reform proposals to separate investment and commercial banking activities are bound to have mixed results. On one hand, they will tend to lower the complexity of banking institutions and improve the resolvability and credibility of resolution procedures, as well as reduce the likelihood of conflicts of interest and interdependencies within group and financial markets. On the other hand, they may increase the supervisory burden and the danger of misidentifying prohibited or permitted activities, and limit scope and diversification economies.

The risk of activities migrating toward less regulated areas, where systemic risk may be reproduced, is always present. The avoidance of regulatory arbitrage with shadow banks can be overcome through by regulating the function or activity, rather than the entity. However, the focus on activities should work alongside prudential regulation and the supervision of entities – both banks and others that perform banking functions (broker-dealers, mutual funds, hedge funds). Regulatory arbitrage across jurisdictions will also be present in the absence of a global regulator that is able to ensure a level global playing field.

Prudential regulation should employ an all-inclusive approach that considers interactions between conduct (capital, liquidity, disclosure requirements, macroprudential ratios) and structural (activity restrictions) instruments.

Coordinating prudential regulation and competition policy

Additionally, prudential regulation and competition policy should be coordinated because of the trade-off between competition and financial stability that is inherent in regulatory imperfections. Indeed, in a more competitive environment, the solvency requirement should be strengthened, with the capital requirement level increasing both the social cost of failure and the intensity of competition for funds in the market.

There are two reasons for this: increased competition for funds aggravates coordination problems of investors and makes runs more likely, and it reduces the charter value of banks by enticing them to take more risk. Many liberalisation episodes, including the S&L crisis in the US and the deregulation that preceded the subprime crisis, overlooked this prudential rule with damaging systemic consequences.

The prudential authority, by imposing restrictions on the actions of banks, makes competition more effective in delivering consumer and investor welfare in a range of situations. Several examples illustrate why we should coordinate competition and prudential policies, including macroprudential ones:

  • When banks exploit deposit insurance and overbid for deposits, inducing other banks to respond and increasing systemic risk, the prudential authority may limit this excessive competition by capping deposit rates. The extreme case is when distressed banks approach insolvency, when the trade-off between competition and stability is the most pronounced. In this scenario, banks should be tightly regulated and their activities should be restricted.
  • When, in expansions, banks have incentives to overlend and consumers to overborrow (perhaps because of behavioural biases), prudential rules may limit the amount of a mortgage loan based on a percentage of the property value, or consumer protection rules may restrict the choice that intermediaries can offer consumers. This restricts competition among banks, reducing credit oversupply and the consequent build-up of risk in the real estate sector.
  • In a crisis, the urge to resolve distressed entities by merging them with good ones may consolidate anti-competitive and TBTF market structures.
  • Prudential regulation can pose a barrier to entry, and regulatory reform drastically increases compliance costs.

There are cases in which prudential and competition policies are naturally aligned and work as complementary tools. For example, competition policy that prevents the distortion of competition by TBTF entities which have received help. In other cases, competition delivers an efficient outcome once the appropriate prudential and consumer protection rules are in place. Either way, if we want to control systemic risk and maintain competitive markets, it is crucial that we align policies.

Regulatory challenges

Establishing regulation and supervisory procedures will be challenging when many of the basic theoretical and empirical foundations of regulation and supervision (for example the theory of capital for banks, or competition between banks and shadow banks) are not fully developed. Also we do not know how much weight to give to rules versus supervisory discretion, although post-crisis the balance seems to have inclined towards discretion. The outstanding questions include:

What measures should we take to avoid the regulatory boundary problem, since many crises stem from the emergence of parallel banking systems that escape regulatory control, such as the 1907 banking crisis in the US or the 2007-09 crisis? Will the new competitors to the banking sector be the new shadow banks in the next crisis?

What systems should we build as reliable early indicators of crises and to help regulators stay ahead of financial innovation? This is extremely difficult. Regulation is typically driven by the previous crisis, not the next one.

Finally, evidence from the history of banking shows that there is room for improved regulation that simultaneously increases the stability of the banking system and boosts effective competition.

References

Baily, M, J Campbell, J Cochrane, D Diamond, D Duffie, K R French, A Kashyap, F Mishkin, R Rajan, D Scharfstein, R Shiller, M Slaughter, H S Shin, J Stein, and R Stulz (2013), “Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group.” Journal of Applied Corporate Finance 25(4): 37-40.

Brunnermeier, M, C Goodhart, A Crocket, A Persaud and H S Shin (2009), The Fundamental Principles of Financial Regulation, 11th Geneva Report on the World Economy, ICMB and CEPR.

European Systemic Risk Board (2014). “Is Europe Overbanked?” Reports of the Advisory Scientific Committee 4.

Reinhart, C and K Rogoff. (2009). This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press, pp. 512.

Vives, X (2014). “Strategic, Complementarity, Fragility, and Regulation”, The Review of Financial Studies 27(12): 3547-3592.

Vives, X. (2016). Competition and Stability in Banking. The Role of Regulation and Competition Policy. Princeton, NJ: Princeton University Press, pp. 344.

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Topics:  Macroeconomic policy

Tags:  Macroprudential policy, global crisis, financial regulation, systemic risk, bank regulation, financial crises, BASEL III

Professor of Economics and Finance and Academic Director of the Public-Private Sector Research Center at IESE Business School; CEPR Research Fellow

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