REMEMBER THAT SILLY old song that tells of a guy who marries a widow with an adult daughter? The daughter marries the guy’s widower father, so becoming both the guy’s step-daughter and stepmother; both couples have children; and through a complex series of family relationships the guy ends up being his own grandfather?
I was, perhaps rather bizarrely, reminded of it while scanning “Interaction, coherence and overall calibration of post-crisis Basel reforms”, an Oliver Wyman report commissioned by the Global Financial Markets Association out last Tuesday. I wondered if the regulatory set-up envisaged for banking and capital markets isn’t emerging from a rather warped parallel version of the song’s narrative.
The highly fragmented, convoluted but always somehow family-related series of joint, stand-alone and competitive processes has given us today’s half-finished banking and capital markets regulatory framework.
These efforts – promulgated by the Financial Stability Board and taken up by the Basel Committee on Banking Supervision and other national and transnational bodies – have in many ways become the FSB’s wayward love child. And the stripling is doing everything in its power to undermine the primordial growth drivers of its overlords at the G20.
Summarising the 170-page report in a sentence isn’t easy or arguably even advisable, but in essence it’s this: Basel should take its foot off the pedal and conduct proper impact assessments including all relevant current and known future inputs.
Then it should reverse its way out of an incoherent framework that’s riven with conflict, redundancy, cross-purposes and unintended consequences. The latter include regulatory arbitrage incentives that are pushing systemic activities into the shadow banking sector.
This framework has unnecessarily high cost and, because it has created excessive levels of bank capital, is undermining bank lending and arresting economic growth – in direct contradiction to the G20’s growth commitments and initiatives.
OK, that’s my summary, but I think it nails it. The report looked at measures that have been agreed on but also at those under active consideration at the Basel Committee, plus the FSB’s TLAC rules.
THE REPORT’S STATED aim is to “consolidate and interpret for ease of use the large and growing base of research on these topics, in order to assist the Basel Committee, and other policymakers and analysts, in their consideration of how to optimize the global regulations”. GFMA’s interpretation of regulatory optimisation is likely to be poles apart from that of Basel, but we’ll let that slide.
GFMA’s steer? Cut out unnecessary duplication or conflicts between specific regulatory requirements and broader policy goals; conduct end-to-end regulatory impact analyses, particularly on capital markets (primary vs secondary, emerging markets, changing dynamics of investment behaviour); be super-sure that regulation is targeting activities at an appropriate level and that risk tolerances around lending are not set too low; hold off on Basel IV until the full impact of Basel III is known.
I love the GFMA’s diplomatic wording here: “The FSB, in consultation with the BIS, and relevant stakeholders in the public and private sector, should develop a mechanism for a principles-based process by which financial regulators would conduct transparent and formalized consultations on a cross-border basis in order to support informed regulatory design and implementation that minimizes conflicts, redundancies and unintended consequences and takes into account the interaction, coherence and overall calibration of financial regulation”.
I think the meaning is clear!
One fundamental question coming out around all this is: what cost bank stability?
IF THE STARTING point is that the initial Basel III package made the banking system more stable and resilient, the cost-benefit analysis was conducted way too early and without all of the proper inputs. We now know that intermediation costs resulting from Basel III are higher and that those higher costs will be (are being) passed onto users of the banking system and the broader economy.
It’s similarly a certainty that regulation has fundamentally changed the shape of banks’ balance sheets and business models, has altered the structure of financial markets, and has negatively impacted liquidity, efficiency and effectiveness.
The 25%–30% contraction in banks’ trading balance sheets since 2010 is just one example where OW says “overall market liquidity could suffer, especially after the full effects of existing regulatory changes and those still in process play out in a more normal interest-rate environment”.
The consultants also referenced estimated costs in the 80bp–110bp range stemming from Leverage Ratio and NSFR requirements on low-margin market-making activities. How about impacts on capital markets? A 60bp–84bp increase in credit spreads? Or on lending? A 2.6% decline in loan volumes for every one percentage point increase in capital ratios? Hardly conducive to promoting economic growth.
One fundamental question coming out around all this is: what cost bank stability? A subsidiary point is that banks may be more stable, but financial markets aren’t. Quite the contrary: they’re susceptible to bouts of rapid and severe volatility. And combined with higher transaction costs – the report points to wider bid-offer spreads combined with a larger effect from higher indirect costs – liquidity premiums are being pushed up.
Here are two teasers to end with, for you to ponder in the warm August sunshine, that speak to the thrust of the report. How and to what extent can intended specific regulatory consequences to promote banking stability have turned into wholly unintended consequences once their myriad cumulative effects are taken into account? And have the effects conspired to undermine the very functioning of the financial system they set out to protect?
As ever, answers on a postcard.
