Have the banking regulations enacted since the Global Financial Crisis gone too far?
The Global Financial Crisis has paved the way to a system that is now conformed by large numbers of detailed and intricate laws and guidelines. Regulations have become so complex and impeding that it’s widely argued they’re stifling innovation and growth in their task to provide much needed stability to the global economy. Although new and ever-growing legislations span thousands of pages, they’re not doing enough to counteract the threat of another crisis and this article focuses on the main reason why. Regulations have become so detailed they’ve become too hard to abide by and oversee. The sheer volume of laws has led banks to find counterintuitive ways to bend and break them through regulatory capital arbitrage. This has meant the capital banks hold is not enough to prevent a repeat of 2008 and efforts should be focused on changing this. The spectrum of this topic is so wide it would be impossible to cover every point; this article portrays the need for further increases in banks’ capital requirements, a keystone in preventing the next financial crisis. I’ll also consider whether banking regulations have gone far enough to quell the risk ‘too big to fail’ banks pose and whether further action should be taken to reduce their size.
Capital is one of the most important concepts in finance. In banking terms, capital consists of equity and retained earnings that can be used to absorb losses and help prevent solvency. Capital is a form of funding used by banks, it does not relate to the cash reserves they hold in vaults or at the central bank. This is a common misconception that is imperative not to be mistaken in respect to this article.
In the wake of the last crisis many economists argue that regulatory capital arbitrage may have intensified its severity. Capital arbitrage allows banks to exploit loopholes in the system so that they can hold less capital in relation to the amount of assets they have, which in turn allows them to be more profitable due to debt being a relatively inexpensive alternative to equity financing. The three main opportunities arise through restructuring transactions, financial engineering and a change in geographical location. During the crisis, systemically important banks (Lehman Brothers, Washington Mutual) that reportedly had sufficient levels of capital in fact crumbled or required the help of the state. Through regulatory arbitrage they were able to hold less capital and have higher levels of leverage, which ultimately led to them to be riskier and more susceptible to economic shocks. This is a problem that will never be solved as large financial institutions have far more resources and knowledge to understand the financial system than regulators do, which allows them to manipulate their balance sheets and reported levels of risk-taking.
Regulatory arbitrage will persist whether the laws are simple or complex, a fact proven throughout Basel’s regulatory framework. Banks, for their own personal gain have manipulated all three of the Basel Accords and although Basel III has made major improvements to their safety, the capital requirements are still far too low and this is where regulations must go further. Bankers will always find ways to game the rules, but by forcing them to hold significantly more capital the impact of regulatory arbitrage will be minimal.
When banks become more capitalised, the losses they take on defaulted loans will be more costly for their shareholders which means banks will take more precaution when issuing loans. The main argument put forward by banks in response to higher levels of capital is that it restricts lending and reduces economic growth. This would be true if it was in response to the cash reserves they have to hold, but holding more equity does not reduce bank lending. The International Monetary Fund (IMF) proved this when they reviewed data since 1999 on the relationship between equity and loan levels for eight US globally systemic banks, finding no evidence that the two were linked. There are three main reasons why banks are so against equity funding and all of them highlight their selfish nature. Firstly, bank profitability is measured by ‘return on equity’. By reducing their equity they can appear more profitable which in turn leads to bankers getting larger bonuses, giving them incentive to reduce equity as much as possible. Secondly, debt funding is tax-deductible whilst dividends paid on equity are not. By using debt to fund lending they can increase return due to a subsidy on tax. Thirdly, there is an implicit guarantee that should a large bank fail they will be bailed out by the government (too big to fail). Because investors expect banks to be bailed out if they become insolvent, they’re willing to take a lower return on bank debt instruments such as bank bonds, which makes debt funding more attractive to equity funding. ‘To big to fail’ banks are one of the key reasons why banking regulations haven’t gone far enough, a topic I will elaborate on further in the article.
How much capital will be ‘far enough’? Basel III currently imposes an equity-to-risk-weighted-assets ratio between 8-13%, with systemically important banks required to hold slightly more. This is a vast improvement on the 2% required prior to Basel III, however many reputable sources suggest the figure should be a lot higher. The Basel Committee on Banking Supervision’s researchers stated the ratio should be between 16-19%. The International Monetary Fund’s researchers believed the ratio should be 18%. The Bank of England’s researchers suggested 20% would be a sufficient amount. All of the above figures suggest the capital banks hold is not sufficient to prevent them from solvency in the event of economic shocks. There is a fear among regulators that increasing capital requirements will cause a credit crunch and will negatively affect the economy. This fear is not backed by figures but merely opinion from the bankers who wish to act in their own best interest, not societies.
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