A proportionate approach to bank regulation
There is talk of the recently-agreed Basel III accord on bank regulation being diluted. Across the world, regulators are trying to address the possible contradiction between being tough on bank regulations and the risk of undermining an already fragile economic situation following bank deleveraging that such a toughening of regulation may imply.
Another concern is that the financial institutions deemed too-big-to-fail or too-interconnected-to-fail helped trigger and worsen the crisis and extracted hundreds of billions in taxpayer support have grown even larger. The relative advantage they enjoy over smaller, more local and more diverse banks has also increased further on the assumption that governments would not let such important institutions fail in this fragile economic environment.
While working with EU authorities, we have suggested an approach that may help partly address these issues as well as deliver on the more important promise of building a financial system that works better for the real economy than the one we have had so far. The basic premise behind our work with EU policymakers in this context is that the regulation of financial institutions, banks in particular, should be differentiated much more than is currently the case on the basis of 1) contribution to systemic risk and 2) usefulness for the real economy.
A more differentiated approach to bank regulations
As things stand now, the European Parliament, Council and Commission are locked in a difficult ‘trialogue’ (negotiations) about the final shape that regulations governing banking in the European Union (the Capital Requirements Directive – CRD and the Capital Requirements Regulations – CRR) should take.
While there are many fault lines, one critical point of conflict is that the parliament wants more stringent regulations for banks, and sensibly so. On the whole, it wants a more strict leverage cap, higher capital requirements, bigger liquidity buffers, more controls on remuneration and restrictions on risk taking. And it wants these to be implemented sooner rather than later. The Council’s general position is to be more lax on most of these parameters and for the regulations to apply later rather than sooner.
Both the parliament and the Council’s positions on how stringent new regulations should be are tempered by three main concerns 1) that these should not harm the fragile real economy 2) that smaller more local and safer institutions should not be unduly penalized and that 3) the EU’s banking industry should remain globally competitive, whatever that might mean.
As long as regulations being discussed for banks treat most of them similarly, the concerns for not penalizing the smaller and safer banks are likely to prove to be the limiting factors in how stringent the compromises would be.
We at Re-Define have been arguing that this standardized approach to regulating banks of all shapes and sizes does not make sense. Instead EU bank regulations should be differentiated according to the particular level of systemic threat that any particular institution’s operations pose to the Member State it operates in and to the whole of the European Union. The usefulness of what the bank does for the real economy should also be taken into account.
This approach addresses the shortcomings of the European Commission’s original draft which does little to distinguish amongst the many different bank models and sizes that are prevalent in the European Union. The Commission’s approach means that whatever regulations are finally agreed on would in all likelihood be too lax for the bigger and the more risky institutions that pose large systemic risk and be too tight for the smaller and the safer institutions that pose little systemic risk.
That is why we have suggested that the provisions of the Capital Requirements directive should apply to EU Financial Institutions in a proportionate manner. The degree of stringency on 1) Capital 2) Leverage Limits 3) Liquidity Ratios 4) Crisis Planning 5) Concentration Limits 6) Reporting Requirements 7) Remuneration Restrictions 8) Risk Management Requirements and 9) Timeline to meet new regulatory requirements should vary according to the Risk Category that the Financial Institution fits into.
In order to implement this approach, we have suggested that all EU banks should be put into one of the following categories:
• G-SIFIs, Global Systemically Significant Financial Institutions, as designated by the FSB
• E-SIFIs, European Systemically Significant Financial Institutions
• D-SIFIs, Domestically Systemically Significant Financial Institutions
• Others where all institutions that are not designated to be systemically significant would fit in
We have also suggested to the Council, Commission and the Parliament that the decision on the categorization of financial institutions into the E-SIFI category should be taken jointly by the European Systemic Risk Boad (ESRB) and European Banking Authority (EBA) in consultation the competent national authority and the college of supervisors. In case of disagreements between national and European authorities the decision of European authorities should prevail.
The designation of institutions into the D-SIFI category should be taken by relevant national competent authorities together with the college of supervisors in consultation with the EBA and the ESRB.
The designation of an institution into a systemically significant category shall be taken on the basis of the following criteria and of the conclusions of the forthcoming Likanen report. 1) The size and nature of assets 2) size and types of liabilities 3) size of off balance sheet activities 4) business models 5) riskiness as assessed under the deposit insurance directive 6) and other factors that may be jointly agreed between the EBA and the ESRB.
We have recommended that as a backstop, any institution with a balance sheet above Euro 250 bn should automatically be designated as a E-SIFI provided it is not already a G-SIFI. Any institution with a balance sheet above Euro 100 bn should be automatically designated to be a D-SIFI if it is not already defined as a G-SIFI or an E-SIFI. In order to account for the different sizes and nature of financial systems and the different sizes of the various Member State economies, any financial institution which has a more than 20% share of the deposit, or liabilities or assets in any MS will be automatically designated as a D-SIFI in the State.
We recommend that a maximum leverage ratio of 20 applies to G-SIFIs, 23 to E-SIFIs, 27 to D-SIFIs and 30 to other financial institutions. Capital, Liquidity, and other aspects of financial regulation listed in the above should also apply on a proportionate and decreasing basis across the four categories of the financial institutions.
Exemptions about particular business models, different liability structures and importance to the real economy can only be made in the ‘Other’ category particularly with a view to promoting the diversity of the financial system, encouraging the development of relationship banking and provision of support to the real economy particularly to the SME sector. Development banks will also fit into this category. Decisions on these can be made by competent national authorities but only in consultation with and the agreement of the EBA.
How this differentiated approach helps in the current context
A critical part of the problem has been that banks particularly large ones, look and act increasingly like each other and this has eroded the natural diversity of the banking system. Another problem has been that the interconnectivity of banks, hence their potential to cause contagion if they get into trouble, has increases more than proportionately with size. A third problem is the substantial implicit subsidy that large and highly-interconnected institutions enjoy, particularly over smaller institutions and how this asymmetry has become worse during the crisis and risks distorting competition further. As discussed at the beginning of this note, concern about the pace of deleveraging and it’s impact on the economy is another key issue that need to be tackled satisfactorily.
Our policy advice to subject EU banks to a tiered regulatory regime helps address all of these issues to some extent. Regulation of the institutions that have the largest contribution to systemic risk should be tightened considerably, beyond simply removing the huge taxpayer subsidy they currently enjoy. The Global SIFIs and European SIFIs would fit into this category. Certain Member States would also need to address Domestic SIFIs that don’t fit into either of the previous categories. The strictness of the regulation should increase from D-SIFIs to E-SIFIs through to G-SIFIs. Institutions that fall outside of these categorizations can be subject to more relaxed regulatory standards, particularly if they follow ‘safer’ business models, have alternative liability structures or business model that contribute to the diversity of the financial system, or are otherwise strongly supportive of the real economy.
This approach will help level the landscape between large and small institutions, improve the diversity of the financial system, ease some of the problems associated with deleveraging as smaller, less systemically risky institutions can step into the void being left by the systemically significant institutions.
Financial regulation needs to be more differentiated to recognize the large differences that exist across the financial system. This will make the system more competitive, fairer, more diverse, relatively more stable and equip it better to support the real economy.
For those worried about smaller financial institutions, such as the Spanish Cajas getting a free ride leading to a repeat of the Spanish crisis, the kind of real estate and asset price bubbles that the smaller banks are susceptible to are best tackled by macro-prudential economy-wide regulations such as adding an additional layer of capital for all banks and tightening the loan to value ratios etc. We will discuss these seperately. Another way forward on this issue is to allow regulators in the EU to capture 'systemically risky activities' as the US Dodd-Frank bill allows US regulators to do now.
The approach discussed in this blog is primarily about how best to handle the distortions to the competitive landscape as well as how to reduce the systemic risk created by financial institutions.
We also strongly suggest that you read this longer, more thoughtful, though somewhat dated, Re-Define Policy Brief on what makes a good banking system.