Reform at what cost?

By Ian Fraser

Published: CA Magazine

Date: April 2nd, 2012

New regulations for banks aim to prevent a repeat of the 2008 meltdown, but are they in fact hampering their ability to do business and aid economic recovery, asks Ian Fraser

During the two decades leading up to the banking crisis, the banks had never had it so good. There was a widespread assumption that financial innovations such as complex derivatives, securitization and the shadow banking system had more or less eliminated risk. Lending skyrocketed, balance sheets ballooned, profits and bonuses soared and some bankers believed they could walk on water. The corollary was that businesses found themselves able to borrow much more money and on much more generous terms than had ever been possible in the past.

Regulators and policymakers, who rather liked the economic growth and tax revenues that a turbo-charged banking sector can bring, turned a blind eye to a multitude of sins. These included the banks’ flawed risk-management systems, wafer-thin capital ratios, excessive leverage, reckless acquisitions and flawed accounting standards which some commentators believe permitted the banks to exist in a “fool’s paradise”.

The era of unstoppable growth abruptly came to an end when many of the world’s largest banks ran out of money and had to be bailed out in October 2008. Since those hair-raising days, the regulatory and political mind-set has changed absolutely.

The banks are facing a tightening regulatory screw, with pressure coming mainly from the Basel Committee on Banking Supervision (part of the Basel-based Bank for International Settlements) and a host of other legislators, regulators and quangos, national and international.

A number of new bodies have also sprung since the crisis to supervise the banking and financial sector, including the European Banking Authority, European Securities & Markets Authority, Prudential Regulatory Authority and the Financial Stability Oversight Council.

The biggest stick with which the regulators are hitting the bankers, as agreed at G20’s Pittsburgh summit in September 2009 – with the final proposals appearing as Basel III in December 2010 – is to force them to hold more capital, with “strategically important financial institutions” (SiFis) obliged to carry proportionately more than their smaller peers.

Major structural changes are being imposed via the “Volcker Rule” in the US and the Independent Commission on Banking (ICB) in the UK. Broadly, these are intended to prevent banks from using their retail deposits, which benefit from a government guarantee and possible bailouts in the event of crisis, to underpin riskier “casino” activities such as proprietary trading, hedge funds and private equity.

Meanwhile, all trading in over-the-counter derivatives market is being forced onto regulated exchanges and through central clearing houses in a further bid to reduce risk and increase market transparency. The Basel III capital and liquidity standards are replacing the earlier Basel II framework, which is now regarded as deeply flawed and a major contributor to the crisis.

Tougher standards have been broadly welcomed by regulators and politicians, who believe that better capitalised banks will be less likely to behave irresponsibly, or to require government bailouts…

Continue reading this article (CA Magazine PDF)

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