Where Now for Banks Regulation?

A commentary from the Chair of Finance on the future of banking regulation following the collapse of Merrill Lynch.

While banks and regulators fight fires round the world, the lurking question is what steps will authorities have to take over the longer term to make sure these events never happen again?

Central banks and regulators have so far been treading on egg-shells, striving to keep banks lending to each other and intervening where needed to support banks in trouble. But as soon as markets return to a semblance or normality, one can expect some brutally frank discussions of what banks are allowed to do and how much capital they will have to hold.

Our regulators and those in the US are wedded to a broadly market-oriented view of life. The FSA, in fact, is the strongest proponent internationally of so-called “Principles-Based Regulation”. Under this approach, authorities set broad rules that financial firms must follow and then allow them to choose the detailed ways in which they satisfy those requirements. US regulators are quite close in mentality to their industry. So it is unlikely that UK and US regulators will introduce swingeing prohibitions on short-selling, cross ownership of banks and insurers and the like.

Much more likely, we see a ratcheting up of the capital requirements that banks face. Banks in all the major banking centres are covered by a set of rules just put in place collectively called Basel II. These were agreed after a long and tortuous set of negotiations between bank regulators from G10 countries and Switzerland. A key aspect of those negotiations was that the regulators aimed to maintain constant the average level of bank capital in the system (though some banks did better or worse individually).

In retrospect that looks to have been a big mistake. In fact, Basel II grew out of concerns that capital levels in banks had slipped. The FSA, the Fed and others were worried that banks had too many opportunities to operate on low capital ratios in the system that operated before Basel II. It is now obvious that a more conservative approach was needed and that the capital levels should have been pushed up when Basel II came in.

We are also likely to see a much greater focus on banks’ business models. Until recently regulators did not worry much whether a bank’s business models was hungry for liquidity, relying excessively on borrowing short to lend long. No one really asked whether the Northern Rock approach of selling mortgages while raising funds through wholesale markets was a stable approach to follow. That probably seems amazing to a lay observer but many people in the industry and the regulatory community have been seduced by the notion that financial engineering permits one to sustain massive risks on a small capital base.

Again, it is unlikely that the authorities with prohibit banks from following one approach or another. But they will tilt the board so that it is very expensive for banks to follow certain approaches by upping the capital required if they do.

The third outcome we are likely to see is that the authorities will look favourably on consolidation. Widespread bank mergers may impair competition but they increase stability and that is likely to appeal to regulators for quite a long time to come. Cross border mergers within Europe are most attractive in this regard. Competition will suffer less if merging banks are active in different markets. There are some difficult issues that the European Central Bank will have to face if more banks in different European countries merge. Right now there is no clear answer about who would pick up the tab if, for example, a Spanish bank with widespread interests in the UK or an Italian bank active in Germany needed bailing out. But that is another story…