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Regulation

The era of counter-intuitive prudential regulation

Posted by on 05 November 2024
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Following the banking failures of 2023, the industry expected regulators to step in to bring balance to the financial system. David Buckham, CEO, Monocle, explores the events that ensued and what they tell us about policy-making and the system as a whole.

Among the austere ranks of global banking regulators, in the libraries of central banks the world over, brushing quietly between the shelves of legal precedent, paging through arcane laws of prudential jurisprudence, squinting over the partial differential calculus that is littered across countless position papers – gazing up from one’s reading, tome in hand, so to speak – one could be forgiven, as a neutral observer, for being puzzled with it all. It makes no sense. Why would the US regulator, on the same day that it announced that the banking system had passed its annual stress test with sufficient capital to survive an “economic catastrophe”, notwithstanding the banking fatalities of 2023, demand that the largest banks, and not the smaller ones that had failed, hold even more capital?

On the 27th of July 2023, Michael Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System, announced a proposal to implement system-wide increases in bank capital requirements. These increases would be applied to all banks with assets over $100 billion, with Barr stressing that the 2023 banking crisis had proven the systemic role played by smaller banks. Yet, counter-intuitively, the new capital rules would disproportionately affect the largest banks, those with over $700 billion in assets, which estimated that they would have to increase their capital by 24%, versus a 9% increase for smaller banks.

Barr’s proposal received unprecedented pushback, with large banks arguing that the rules were unnecessary given the regulatory fortification that banks have already undergone since the Global Financial Crisis. They also stressed that increasing capital requirements would have only a marginal effect on the safety of the largest banks, while compromising their competitiveness and capacity to lend. And then there was the sheer gobsmacking illogicality of Barr’s proposal, which would effectively punish large banks for a crisis that had occurred among their smaller peers. These smaller banks received enormous amounts of deposits during the Covid cash-rush years and subsequently over-invested in Treasury bonds that had been incorrectly priced using old fandangled accounting methods. When interest rate hikes began, a liquidity crisis ultimately ensued that had nothing to do with capital. Barr’s proposal was roughly equivalent to introducing new aerospace regulations following a spate of car accidents on the roads.

For once, in a public duel between regulators and banks, there was an outright winner. On the 10th of September this year, Barr announced that the increase in capital requirements would be reduced to 9% for systemically important banks, displaying a degree of humility never before seen in a regulator. Barring perhaps Alan Greenspan, who confessed after the Financial Crisis that he had “found a flaw” in his beliefs about the workings of the financial system. In a statement that was, relatively speaking, otherworldly, Barr said, “Life gives you ample opportunity to learn and relearn the lesson of humility”. You cannot make that up.

But this is not the first time that banking regulations have been introduced in a highly reactive and counter-intuitive manner, and with a failure to fully consider their potential consequences. Immediately following the Financial Crisis, higher capital requirements were also implemented, forcing banks already brought to their knees to try to attract higher levels of equity at the very moment they had become unattractive from an investment perspective.

This kind of reactive approach to regulation is not isolated to the banking industry. There is a great rush to impose taxes and restrictions on world trade, which too will have unintended consequences. The EU’s Carbon Border Adjustment Mechanism (CBAM) will impose tariffs on certain imports as part of the EU’s attempt to reduce its carbon equivalent emissions. Embedded in this policy resides the far loftier goal of pressuring the developing world to align their decarbonisation policies with those of developed countries. This unilateral decision by the EU completely disregards the economic circumstances of poorer nations. Developing countries are being penalised by climate-related policies, even though they have historically contributed the least emissions.

In many ways CBAM can be understood as a continuation of a long history of the developed world introducing policies that appear to be driven by enthusiastic participation in the project of globalisation, but which are ultimately self-serving. When the 1988 Basel Accord was introduced, it made an arbitrary distinction between the riskiness of bank assets between OECD countries, which received a 0% risk-weighting, and non-OECD countries, which received a 100% risk-weighting. This greatly hampered developing countries’ ability to compete in the global banking market.

The long-run effect of these kinds of policies, introduced disingenuously in the name of addressing matters of global concern, is that developing nations are strengthening their alliances with countries such as China, Russia, and Saudi Arabia, increasing the geopolitical power of these authoritarian states and undermining the global project of democracy.

About the author

David Buckham is the founder and CEO of specialist management consultancy, Monocle. He will be presenting on the above topic at RiskMinds International on Monday 18 November.

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