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.

The regulated banking system

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%. Since then, 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 affect both macroeconomic trends and structural features of markets.

“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.

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:

  • First, the traditional, individual-firm or microprudential approach to capital regulation has been enhanced under the guidance of the Basel Committee on Banking Supervision. The so-called Basel 2.5 agreement revised and strengthened market risk requirements of Basel II (the international accord on banking laws and regulations). Subsequently Basel III upgraded the quality and increased the quantity of minimum capital requirements. Basel III requires banks to hold a minimum of 4.5% of core tier 1 equity against risk weighted assets, compared with 2% under Basel II. In addition, Basel III mandated a capital conservation buffer of 2.5% of assets, to be held in the form of core tier 1 equity, and a discretionary counter-cyclical buffer of up to 2.5%. Moreover, the definition of regulatory capital and the calculation of risk weighted assets have been tightened. The BIS estimates that 1 percentage point core tier 1 capital ratio under Basel III corresponds to 0.78 percentage point for that ratio under Basel II (view post here).
    In addition, Basel III sets a 3% minimum leverage ratio, defined as the ratio of core tier 1 capital to consolidated but un-weighted assets. Additional leverage ratio requirements may be imposed on global systemically important banks.
    Capital adequacy and leverage ratios have different purposes. Capital adequacy ratios serve to limit the risk that banks’ equity can easily be eaten up by a market-wide decline in the value of high-risk assets. Leverage ratios limit the debt financing of assets, irrespective of the risk characteristics.
  • Second, there has been the introduction of a more innovative macroprudential component of capital regulation (view post here). The counter-cyclical buffer mentioned above is one such measure. Beyond this, macroprudential reforms include a capital surcharge based on the global systemic importance of the largest banking organizations, raising the required holding of core tier 1 capital  by between 1% and 2.5% of risk-weighted assets. Put differently, the new Basel framework will require a capital buffer that increases with a firm’s size, complexity, interconnectedness and global footprint. Beyond providing additional loss absorbing capacity, this capital buffer requirement will act to offset funding advantages for large global banks, helping to level the playing field.
    Higher loss absorbency requirements for globally systematically important banks have been introduced on 1 January 2016 and become fully effective on 1 January 2019.
  • Third, the regulatory authorities have introduced regular stress testing and capital planning. In the U.S. this reform thread is based on the Dodd-Frank requirement for stress testing at large banks, but more generally in the Federal Reserve’s establishment of a formal annual capital planning requirement for these firms.

“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

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:

  • Regulated banks themselves have argued that equity is more expensive than debt because it is riskier. This implies that increasing the equity share in the capital structure (i.e. decreasing banks’ leverage) would adversely affect banks’ realized return on equity, and increase the likelihood of eventual bankruptcy that would impose losses on holders of bank equity and bank bonds. The intention of regulators to ensure that future bank bankrupcies lead to bondholder-funded bail-ins rather than government-funded bail-outs adds to the risks that bondholders face. The banking industry has claimed that the return on equity required by investors to hold banks’ equity would be broadly insensitive to the decrease in leverage, thus leading to a material increase in funding costs, while lenders to banks will require compensation for bail-in risks. This would translate into a higher cost of credit for clients and counterparties and possibly in lower credit availability. Altogether, estimates of economic losses arising from higher capital ratios range between a 5 bps reduction in annual GDP growth over 4 years to a 30-60 basis points annual loss over 5 years (view post here).
  • Sovereign debt typically bears little or no risk weight. Hence, tight capital regulation increases banks’ proclivity to holding government debt, particularly where such debt is paying significant credit spreads. This raises the risk of systemic crisis through sovereign-bank feedback loops (view post here), particularly in countries where governments have limited influence on the central bank, such as in a currency union.
  • The broader bank capital, derivatives, and resolution reforms are likely to foster the ongoing expansion of collateralized versus unsecured lending. This could further increase bank asset encumbrance (pledging of assets for specific transactions) and, as a consequence, unsecured institutional creditors’  risk of statutory bail-in (view post here). Excessive asset encumbrance could undermine a bank’s resolution in distress. Rising costs of unsecured bank debt could lower its share below what is required for loss absorption.
  • Moreover, the tighter and more complex capital rules are, the greater the incentive to gear balance sheets towards using all remaining degrees of freedom, a process that is called “capital arbitrage” (view post here). This has two problematic consequences. First, risk weights used to calculate capital adequacy ratios may understate true portfolio risk, undermining the credibility of regulation. Second, banks may dedicate considerable human resources and misallocate financial resources to that end.
  • The introduction of a non-risk based leverage ratio is likely to encourage some banks that specialize on low-risk lending to raise their share of high-risk loans. On aggregate this would make bank portfolios more similar across the industry and increase the systemic risks emanating from rising defaults in specific sectors and economies (view post here).

“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

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).

“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

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.

  • A new liquidity coverage ratio is being phased during 2015-2019. It requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress (view post here). The idea is that the disposal of such assets will not easily escalate into fire sale dynamics. However, quality and liquidity of various markets is uncertain and there is a risk that banks would actually prefer to sell lower-quality assets in a liquidity crisis, in order to maintain their liquidity coverage ratio.
  • A new net stable funding ratio is to be introduced in 2018. It focuses on a one-year time horizon and establishes a minimum amount of stable funding each bank must obtain based on the liquidity characteristics of its assets. There are concerns about is structural impact, because it interferes with the essential role of banks in maturity transformation, affects functioning of conventional monetary policy, and may encourage migration of financial transactions into the shadow banking system (view post here). The impact of a net stable funding requirement may vary greatly across countries.
  • The large exposure framework of the Basel Committee on Banking Supervision will impose limits on banks’ exposure to single counterparties. As exposures to central banks and governments are exempt it will probably introduce distortions and encourage more central bank financial intermediation.
  • Banks are also a major liquidity provider in the huge OTC (“over-the-counter”) derivatives market. Its vulnerability convinced the G20 in its 2009 Pittsburgh Summit to stipulate that all standardized derivative contracts be moved onto central counterparty (CCP) clearing platforms, and that the remaining non-standard derivatives require higher capital requirements. In principle, this push should facilitate risk management and the mutualization of default losses. The drawback is an unprecedented concentration of risk in a few global central counterparties and their members (view post here). For this reason, CCPs are required maintain sufficient liquid resources, including the collection of initial and variation margins and default arrangements. However, CCP margin calls or calls on unfunded liquidity arrangements could themselves propagate crises by aggravating scarcity of liquid assets and collateral (view post here).

“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

“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