Time to revisit bank regulation

Andreas Dombret, Vorstandsmitglied der Atlantik-Brücke, analysiert in einem zuerst in den Financial News erschienenen Gast-Kommentar mögliche künftige Risiken der Banken-Regulierung und gibt Anstöße für eine Reform des globalen Systems der Kreditinstitute.

Von Andreas Dombret

„Never again“ was the mantra of policymakers and regulators in the wake of the 2007-08 Global Financial Crisis. Forestalling the collapse of the global financial system involved pumping in huge sums of public money, not to mention the costs incurred by taxpayers as economies were plunged into recession.

The regulatory reforms enacted in the wake of the GFC were designed to ensure that never again would taxpayers be on the hook for excessive risk-taking in the financial sector.

Yet little over a decade later, policy makers are back there again, confronting a loss of confidence in parts of the banking system and having to put public money at risk. It is mercifully not on the scale of the GFC but it was not meant to happen this way.

Last month the Swiss Government made use of emergency powers to rescue Credit Suisse through a merger with UBS while the Swiss National Bank made extra liquidity support available. In addition, Swiss taxpayers are now on the hook for potential losses on some of the bank’s hard-to-value assets, which are in run off.

Meanwhile in the US, the collapse of Silicon Valley Bank forced regulators to be flexible about the rulebook on deposit insurance for medium-sized banks. They offered a blanket 100% guarantee to all SVB’s depositors. A new liquidity scheme, backstopped with taxpayers’ money, was set up by the Federal Reserve to help out all the other regional banks suffering from deposit withdrawals. Furthermore, banks were allowed to borrow under the scheme by posting collateral at face value, even though some bonds in question were trading well below that.

It is true that the reforms enacted after the GFC have ensured that today’s banking system is much sounder, much better capitalised and a lot more liquid than a decade ago. This made the recent liquidity problems much easier to contain.

However, it is also true that the regulatory architecture needs revisiting and strengthening. We live in a much more volatile, febrile world than a decade ago. Developments in social media and technology have made banks more prone to panics and runs. Customers can now withdraw deposits from their bank at any time of day or night just with a few clicks on a smartphone. As a result of these changes, living wills and resolution mechanisms have been found wanting, while complexity is increasing.

There are already moves afoot to toughen up liquidity requirements for smaller and medium-sized US banks, which is long overdue. In the meantime, we need a fundamental reappraisal of the resolution system for Globally Systemically Important Banks to address what went wrong at a too-big-to-fail institution like Credit Suisse. One major reason Credit Suisse experienced a bank run was due to a loss of confidence in its business model despite having been adequately capitalised.

There are five issues that regulators should be thinking about:

First, we have only just emerged from this latest crisis and now is not the right time for softening bank regulation. There are always valid arguments to be made about the risk weightings attached to different asset classes, or about the liquidity requirements for banks, required under Basel III. However, in the current climate I believe regulators will see their priority as reinforcing confidence in the system.

Deposit insurance limits also need reviewing. This is already under consideration in the US and the UK, while the EU still needs to solve the issue of a common Eurozone deposit protection scheme. The backstop of the ESM, the European Stabilisation Mechanism, is capped at €68bn, while the FDIC is de facto unlimited. There are understandable concerns about burden sharing and mutualisation of risk in Europe but there are creative ways this can be addressed, e.g. by using reinsurance mechanisms. In a full-blown crisis, any banking union is going to come under strain if its deposit insurance scheme lacks credibility. Without a credible pan-European scheme, there is always the risk of a bank run in one country leading to depositor flight in another European member state.

The third question is the ‘too-big-to fail’ dilemma, which is very much back on the agenda. The US has the Volcker Rule in Dodd-Frank, which restricts proprietary trading by banks. The UK introduced the Vickers ring-fencing proposals which make it easier to wind down banking groups in the event of failure by keeping retail banking activities separate. In the EU, however, the 2012 Liikanen Report, which addressed the similar issue as Vickers of a firewall between retail and investment banking but in a different way, has been quietly shelved. It is clear that there are different ways to address this problem, and I do not wish to offer a suggestion. Whichever is their preferred option, regulators need to think about addressing the resolvability of G-SIBs in Europe.

Furthermore, there is the impact of other financial players on the highly-regulated banking sector. Trading activities of hedge funds, for instance, as well as easy to manipulate credit default swaps can have a destabilising impact on banks, as we saw during the recent crisis. Are we drawing the regulatory perimeter in the right place? This is another issue that regulators need to reflect on.

Finally, in all of this regulators should not forget moral hazard. Perhaps it is an illusion that in a crisis the resolvability of banks can be handled without any use of public money, but as far as possible the principle of moral hazard needs to be upheld.

Markets have settled down since the crisis over Silicon Valley Bank and Credit Suisse erupted, but it is by no means clear that the banking industry’s problems are all over. Rising interest rates have left many banks sitting on losses on their bond holdings and we have yet to see the impact of higher interest rates on credit portfolios. There are problems lurking in the commercial real estate sector, mostly but not exclusively in the US. You only have to walk down shopping malls on both sides of the Atlantic and see the number of vacant properties to know that many landlords are suffering. Meanwhile developing countries are labouring under the burden of higher interest rates on their borrowings.

I am certain regulators will get ahead of these potential dangers and give thought to the reforms that are needed to strengthen the global banking system.

After a career in investment banking Andreas Dombret served on the Executive Board of Deutsche Bundesbank, the Supervisory Board of the ECB and the Board of Directors of the BIS. He now advises selected financial institutions and is a Global Senior Advisor to international consultancy firm Oliver Wyman.