Regulating the banking sector
Part I. Setting the scene
JULY / 2022
Having just completed a project in Uzbekistan, and witnessed first-hand the impact of the last few years of reforms, the current plans for banking sector overhaul have provoked an existential thought process about banking regulation and the role banks play in the financial crises. Immediately questions arise: can the inherent shortcomings of the banking sector be regulated away through smart policy and what are the options?
Systemic risk
It is generally accepted that systemic risk cannot be wished away completely through will or regulation due to its inherent nature but the blow can be softened and repercussions minimized through careful management such as the Basel Accords and various tools at the national level. But as with everything there are sacrifices to be made and, in this case, it is the banks’ profitability that is being sacrificed.
Banking regulation has a purpose. European Central Bank, for example, identifies it as “preservation of financial stability”: undisrupted financial flows, access to funds, ability for actors to make payments on time and sustainable growth of the economy. However, financial stability is regularly disrupted by systemic risk - a “shock that will trigger a loss of economic value or confidence in…a substantial portion of the financial system” (International Monetary Fund, 2010).
Economies are cyclical. There are booms with economic growth, risk-taking, inflating asset prices, increased borrowing, consumption and investment and build-up of capital, and busts resulting from internal or external shocks with subsequent price correction and loss of capital. Systemic risk is inherent to the pro-cyclical financial system which is based on the interaction of risk and return. In the growth phase risk builds up as agents look for profitable investment opportunities, borrow excessively and take on greater risks believing this will go on to infinity. This expectation destabilizes the financial system. A sudden shock leads to price correction as banks rush to sell their assets at fire-sale prices destroying value in order to maintain liquidity.
Systemic risk cannot be fully eliminated without full disbandment of the banking industry which is not even a matter of discussion. The only viable pathway is the reduction of systemic risk through various tools which make up the banking regulatory framework. It is the size of the recession and the speed of recovery that is the focus rather than elimination of systemic risk and prevention of crises.
It is generally accepted that systemic risk cannot be wished away completely through will or regulation due to its inherent nature but the blow can be softened and repercussions minimized through careful management such as the Basel Accords and various tools at the national level. But as with everything there are sacrifices to be made and, in this case, it is the banks’ profitability that is being sacrificed.
Banking regulation has a purpose. European Central Bank, for example, identifies it as “preservation of financial stability”: undisrupted financial flows, access to funds, ability for actors to make payments on time and sustainable growth of the economy. However, financial stability is regularly disrupted by systemic risk - a “shock that will trigger a loss of economic value or confidence in…a substantial portion of the financial system” (International Monetary Fund, 2010).
Economies are cyclical. There are booms with economic growth, risk-taking, inflating asset prices, increased borrowing, consumption and investment and build-up of capital, and busts resulting from internal or external shocks with subsequent price correction and loss of capital. Systemic risk is inherent to the pro-cyclical financial system which is based on the interaction of risk and return. In the growth phase risk builds up as agents look for profitable investment opportunities, borrow excessively and take on greater risks believing this will go on to infinity. This expectation destabilizes the financial system. A sudden shock leads to price correction as banks rush to sell their assets at fire-sale prices destroying value in order to maintain liquidity.
Systemic risk cannot be fully eliminated without full disbandment of the banking industry which is not even a matter of discussion. The only viable pathway is the reduction of systemic risk through various tools which make up the banking regulatory framework. It is the size of the recession and the speed of recovery that is the focus rather than elimination of systemic risk and prevention of crises.
International regulatory framework
Banking regulation encompasses pro-cyclicality, interconnectedness and behavioral aspects of risk-taking in its attempt to preserve financial stability. Policy can be aimed at either minimizing the amplitude of economic cycles, creating a safety net for the banks to rely on, or cleaning up the system of loss-making zombie banks (Kaufman, 1996: p.28). Governments can also just inject liquidity into failing banks in a bailout policy but this creates a moral hazard problem, underestimation of risk and more risking-taking behavior (diminishing popularity with the voters).
International regulation and specifically Basel II and Basel III, aim to regulate the banking sector and maintain financial stability through ensuring sufficient capitalization and liquidity held by the banks.
In 2004 Basel II was introduced outlining capital requirements for financial institutions and other traders of debt. The idea was to ensure that internationally active banking groups maintain a total capital ratio of 8%. In response to the 2007-2008 crisis work started on Basel III to update the framework with lessons learned. Basel III introduces liquidity coverage ratio, counterparty credit risk, minimum leverage ratio, liquidity buffers and measures to reduce moral hazard.
The focus of both Basel II and III is the creation of a safety net for the bank to manage its liquidity in a recession scenario and prevent excess leverage in a growth phase. In times of liquidity shortage it should allow banks to have sufficient cash for daily operations and to address their market positions without the detrimental impact on asset prices. Capital requirements also restrict banks from taking excessive risks and lending to high-risk ventures which have a high probability of failure.
Banking regulation encompasses pro-cyclicality, interconnectedness and behavioral aspects of risk-taking in its attempt to preserve financial stability. Policy can be aimed at either minimizing the amplitude of economic cycles, creating a safety net for the banks to rely on, or cleaning up the system of loss-making zombie banks (Kaufman, 1996: p.28). Governments can also just inject liquidity into failing banks in a bailout policy but this creates a moral hazard problem, underestimation of risk and more risking-taking behavior (diminishing popularity with the voters).
International regulation and specifically Basel II and Basel III, aim to regulate the banking sector and maintain financial stability through ensuring sufficient capitalization and liquidity held by the banks.
In 2004 Basel II was introduced outlining capital requirements for financial institutions and other traders of debt. The idea was to ensure that internationally active banking groups maintain a total capital ratio of 8%. In response to the 2007-2008 crisis work started on Basel III to update the framework with lessons learned. Basel III introduces liquidity coverage ratio, counterparty credit risk, minimum leverage ratio, liquidity buffers and measures to reduce moral hazard.
The focus of both Basel II and III is the creation of a safety net for the bank to manage its liquidity in a recession scenario and prevent excess leverage in a growth phase. In times of liquidity shortage it should allow banks to have sufficient cash for daily operations and to address their market positions without the detrimental impact on asset prices. Capital requirements also restrict banks from taking excessive risks and lending to high-risk ventures which have a high probability of failure.
National regulatory framework
On a national level central banks may, in addition to or in combination with the Basel Accords, decide on certain approaches and impose measures impacting the banking sector in order to maintain financial stability.
For this purpose, some central banks look to manage foreign currency reserves of individual banks such as limitations on foreign currency operations. An alternative is regulation of capital requirements and liquidity compliance which looks at commercial banks’ capital and risk management systems to identify internal control deficiencies. Finally, banks can register with a deposit insurance system which protects savings of individuals and SMEs as a measure to prevent a collapse in case of a bank run.
Hence, national banks by extension of Basel Accords requirements can implement their own measures which positively impact the banks’ susceptibility to crises through caps and limitations or through good corporate governance.
On a national level central banks may, in addition to or in combination with the Basel Accords, decide on certain approaches and impose measures impacting the banking sector in order to maintain financial stability.
For this purpose, some central banks look to manage foreign currency reserves of individual banks such as limitations on foreign currency operations. An alternative is regulation of capital requirements and liquidity compliance which looks at commercial banks’ capital and risk management systems to identify internal control deficiencies. Finally, banks can register with a deposit insurance system which protects savings of individuals and SMEs as a measure to prevent a collapse in case of a bank run.
Hence, national banks by extension of Basel Accords requirements can implement their own measures which positively impact the banks’ susceptibility to crises through caps and limitations or through good corporate governance.
Bank business model
A quick note on the bank business model. A bank is designed to earn a profit on the difference between the interest rate of short-term deposits and long-term lending. The driver of the decision to lend is the risk-return trade-off where higher risk results in higher returns as investors need a premium for taking on greater risk such as lending to a new venture or a start-up. Similarly, a longer-term loan would carry greater risk and thus a premium for the time-value of money and longitudinal increase in credit risk. Banks are able to generate greater profit by lending to higher risk counterparties for longer or by selling higher risk products that are more price-volatile.
A bank’s default risk is thus made-up of leverage risk, counterparty risk and liquidity risk so that a bank can fail either as a result of a liquidity shortage usually derived from counterparty sources or insolvency being unable to cover its daily cash outflows.
The Basel framework attempts to address this default risk through:
Group consolidation provisions to limit risk-shifting outside the group address leverage risk and the related risk-taking behavior;
Capital deductions for capital requirement calculations clauses, introduction of counterparty credit risk, buffers to allow repayments on short-term obligations when depositors call all at once address the counterparty credit risk of the interconnected financial system;
Imposition of liquidity limitations to ensure that in a recession the bank will have sufficient liquid assets to service its own obligations aim to address liquidity risk as a result of pro-cyclicality of the financial system.
These limitations directly impact the business model of a bank as they rein in the profit-making capacity such that the bank cannot convert its short-term deposits into long-term loans and is unable to attract depositors by offering them more favorable terms creating a conflict of interest between the bank and regulator (Davis, 2019: p.2).
A quick note on the bank business model. A bank is designed to earn a profit on the difference between the interest rate of short-term deposits and long-term lending. The driver of the decision to lend is the risk-return trade-off where higher risk results in higher returns as investors need a premium for taking on greater risk such as lending to a new venture or a start-up. Similarly, a longer-term loan would carry greater risk and thus a premium for the time-value of money and longitudinal increase in credit risk. Banks are able to generate greater profit by lending to higher risk counterparties for longer or by selling higher risk products that are more price-volatile.
A bank’s default risk is thus made-up of leverage risk, counterparty risk and liquidity risk so that a bank can fail either as a result of a liquidity shortage usually derived from counterparty sources or insolvency being unable to cover its daily cash outflows.
The Basel framework attempts to address this default risk through:
Group consolidation provisions to limit risk-shifting outside the group address leverage risk and the related risk-taking behavior;
Capital deductions for capital requirement calculations clauses, introduction of counterparty credit risk, buffers to allow repayments on short-term obligations when depositors call all at once address the counterparty credit risk of the interconnected financial system;
Imposition of liquidity limitations to ensure that in a recession the bank will have sufficient liquid assets to service its own obligations aim to address liquidity risk as a result of pro-cyclicality of the financial system.
These limitations directly impact the business model of a bank as they rein in the profit-making capacity such that the bank cannot convert its short-term deposits into long-term loans and is unable to attract depositors by offering them more favorable terms creating a conflict of interest between the bank and regulator (Davis, 2019: p.2).
Conflict of interest
With respect to the impact of regulation on bank performance Bludnell-Wignall and Atkinson (2010: p.5-6) point out several:
Although Basel III aims to bring OTC derivatives onto exchanges, there is ample opportunity to make profit with tailor-made derivatives which are unsuitable for mass trading on exchanges. To manage counterparty credit risk banks issue loans which renew upon their 12-month maturity making them short-term for asset classification but long-term for operational purposes.
As long as there are exemptions and out-of-scope clauses, banks will always look for opportunity of regulatory arbitrage such as the case of insurance companies being regulated by another body creating opportunity to shift risks outside the banking group. Regardless of the loopholes, regulation does impact banking profits. Is it possible for banks to retain sufficient profitability while complying with regulatory requirements without resorting to innovative finance?
With respect to the impact of regulation on bank performance Bludnell-Wignall and Atkinson (2010: p.5-6) point out several:
- The risk-weighted approach leads to banks intentionally assembling their portfolios from low-risk assets with a lower rate of return;
- The leverage ratio of Basel III prevents the bank from lending to risky but potentially profitable ventures. Alternatively, a bank manager being severely restricted will choose to gamble and place his bets on lucrative but potentially profitable ventures increasing the bank’s susceptibility to risk;
- Basel III also considers provisioning for expected future losses on portfolios to reduce pro-cyclicality which is arbitrary as forecasting future outflows is very difficult and in accounting terms undermines the bank’s bottom line which for a commercial bank may impact its share price and funding opportunities;
- Buffers which must be built-up again if depleted by utilizing the funds that would normally be available for dividends and staff bonuses, limits the capital in use and indirectly affects performance by raising shareholder and staff dissatisfaction (resulting in the sale of shares and high staff turnover);
- The liquidity ratio in Basel III is biased towards government bonds which are considered safe and liquid but can be very risky in some jurisdictions. They are also low return assets which will affect high-risk lending activities.
Although Basel III aims to bring OTC derivatives onto exchanges, there is ample opportunity to make profit with tailor-made derivatives which are unsuitable for mass trading on exchanges. To manage counterparty credit risk banks issue loans which renew upon their 12-month maturity making them short-term for asset classification but long-term for operational purposes.
As long as there are exemptions and out-of-scope clauses, banks will always look for opportunity of regulatory arbitrage such as the case of insurance companies being regulated by another body creating opportunity to shift risks outside the banking group. Regardless of the loopholes, regulation does impact banking profits. Is it possible for banks to retain sufficient profitability while complying with regulatory requirements without resorting to innovative finance?
Find out in Part II of this article series on banking regulation.
References:
- Bank for International Settlements (2005) International Convergence of Capital Measurement and Capital Standards. A Revised Framework. Bank for International Settlements.
- Blundell-Wignal, A., Atkinson, P. (2010) “Thinking beyond Basel III: Necessary solutions for capital and liquidity.” OECD Journal: Financial Market Trends. 2010(1), 1-23.
- Davis D. D., Korenok, O., Lightle, J. P. (2019) “Liquidity regulation, banking history and financial fragility: An experimental examination.” Journal of Economic Behavior and Organization.14(8), 1-12.
- European Central Bank (n.d.) Financial stability and macroprudential policy.
- Kaufman, G. G. (1996) “Bank Failures, Systemic Risk, and Bank Regulation.” Cato Journal. [Online]. 16(1), 17-45.
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