Banking Regulation

The globe’s financial systems are still vulnerable to contagion. Critics say regulators are unlikely to fix the problem unless they shift gears.

Although many big banks have been bailed out, recapitalized and returned to profitability, the global financial system remains fragile six years after what some refer to as the Great Financial Crisis (GFC) brought the world to the brink of depression. The primary reason is that financial institutions are subject to market risk, the result of their dependence on capital instead of cash reserves. And their continued interconnectedness, reflecting the credit they extend to one another for short-term funding and the correlation among their assets, doesn’t help matters. Nor does the so-called “shadow” banking sector, which continues to expand unabated.

To be sure, banks are on more-solid ground than they were six years ago, thanks in part to regulatory reform under the international banking regime Basel III. A large part of that reform has involved the raising by banks of more, and stronger, capital.

According to the latest Global Financial Stability Report by the International Monetary Fund, the majority of a sample of more than 1,500 banks identified by SNL Financial as “advanced economy” banks now have Tier 1 common capital, which includes common equity, retained earnings and certain preferred stock, equal to at least 8% of their assets, whereas only a minority had that much in December 2008.

The improvement is most dramatic in North America, where more than 90% of those financial institutions now have at least that much Tier 1 common capital, compared with fewer than 10% six years ago.  More than 90% of the banks sampled in the euro area also have Tier 1 common capital of at least 8% of assets, whereas fewer than 30% had that much in December 2008. Lesser but similar turnabouts in capitalization have been seen at sampled banks in the rest of Europe and the Asia-Pacific region.

Euro area banks could see further improvement in their capital positions soon, as the latest round of stress tests by the European Central Bank show that some would not stand up well to another crisis.

The IMF did not report data for emerging markets banks, but experts say they pose little systemic risk, because they’re considerably smaller than banks in developed markets and engage to a much lesser degree in derivative transactions. In addition, regulators have more timely data on their assets.

“Under Basel III, it is safe to say that banks are in a better position now, compared to where they were before the GFC,” Amando Tetangco, governor of the Bangko Sentral ng Pilipinas, says.

But Tetangco concedes the global bank reform agenda “is not yet complete.” He says elements of that agenda have been defined under Basel III, but various measures have yet to be implemented. Those, he explains, are aimed at expanding what he calls “the regulatory writ” to shadow banking, which consists chiefly of investment funds and other largely unregulated intermediaries whose risk-taking is seen as a threat to those banks with whom they do business; at enhancing the infrastructure for over-the-counter derivatives; and at avoiding “too big to fail” situations. Tetangco says that “significant progress has been achieved toward stabilizing the financial system.” But, he adds, “we need to continue to pursue the reform agenda.”

D’Arista, professor emeritus: Putting capital in place was the worst thing we could have done. Systemically, it’s a disaster.

In a chapter devoted to shadow banking, the IMF’s latest Global Stability Report urged regulators to take “a more encompassing approach to regulation and supervision that focuses both on activities and on entities and places greater emphasis on systemic risk.” Some experts go further. They contend that Basel III and related efforts, such as the Dodd-Frank Act in the US, do little to reduce systemic risk because they don’t adequately address the interconnectedness of banks, and so will continue to fall short unless key parts of the current reform agenda are rethought.

One institution’s failure can still threaten to take others down, these critics say, as was the case with Bear Stearns, Lehman Brothers and AIG in the lead-up to the crisis. And, they contend, the potential for a painful game of financial dominos remains in place as a result of the exposures big banks have through loans and other credit they have extended to other banks, including derivatives contracts or short-term loans known as repurchase agreements—or repos for short. 

New reports required by the Federal Reserve from the 33 US and foreign institutions considered under Dodd-Frank to be too big to fail show, for example, that Morgan Stanley has the biggest counterparty exposure, at 65% of its assets. Six other “globally systemically important banks” (G-SIBs) have exposures to other banks that are in excess of 10% of their assets. Goldman Sachs’ exposure to other banks is the second-largest, at close to 40%.

Dodd-Frank was supposed to address this through the Volcker Rule, which gets banks out of the business of owning hedge funds, and with it, a lending activity known as prime brokerage. And these changes may help reduce counterparty risk going forward.

The law’s provisions regarding derivatives may also help reduce such risk by requiring banks to post collateral to back their positions and sending more derivatives transactions through exchanges or clearinghouses. Like the Volcker Rule, however, the derivatives rules only recently went into effect.

In addition, Dodd-Frank requires regulators to take into account banks’ use of repos and derivatives when determining how much debt they have. And the Federal Reserve has proposed a capital surcharge on too-big-to-fail institutions that rely heavily on such credit for their short-term funding. But the Fed just began in January tracking how much exposure the 33 G-SIBs have through such holdings.

Worse, some observers worry that those measures will fall short even when fully implemented. “It’s not enough,” asserts University of Massachusetts economics professor Gerald Epstein, who, with his former faculty colleague Jane D’Arista, has also written a paper on Dodd-Frank’s provisions that address counterparty risk, entitled “Dodd-Frank and the Regulation of Dangerous Financial Interconnectedness.” In it Epstein and D’Arista note that the specific provisions require “rigorous enforcement and vigilant oversight.”

Of course, as central bank governor Tetangco points out, the reform agenda is not yet fully implemented. But the exposures of Morgan Stanley and Goldman Sachs, at least, suggest that the banks haven’t done much to reduce them on their own, and the regulators haven’t done much to encourage them to do so.

Moreover, D’Arista, a former staff economist for the US Congress who is now retired from teaching, contends the problem is compounded by regulators’ reliance on bank capital instead of cash reserves to cushion losses. She notes that banks’ capital cannot help but rise and fall together with their assets, making banks more fragile than they were when the Federal Reserve required them to hold cash equal to 10% of their assets. Those reserve requirements were gradually eliminated with the advent of the first Basel agreement in 1985.

“Putting capital in place was the worst thing we could have done,” D’Arista says. “Systemically, it’s a disaster.” She and Epstein aren’t alone in worrying about the correlations among bank assets. Co-Pierre Georg, a lecturer in the school of economics at the University of Cape Town who has written extensively on the topic, says bank interconnectedness is very “stubborn,” perhaps because banks believe the fact that other banks are doing business with them signals that they are healthy. But as a result, he says, they tend to hold many of the same assets.

Georg says the problem may not be solvable through regulation, at least as currently conceived. He observes that Basel III’s continued emphasis on risk weightings, under which more capital must be held against assets that are deemed riskier and less against those deemed less risky, “creates an incentive to become more correlated.” That is because banks will gravitate toward assets that allow them to minimize their capital, including sovereign bonds, derivatives and interbank loans.

Georg asserts, “Regulation has not adequately addressed the issue” of correlation. And although he concedes that banks’ improved capital position may help them better withstand another meltdown, he points out: “Only the next crisis will tell for sure.”