How strict should banks be regulated? Even more than eight years after the outbreak of the financial crisis, there appears to be no simple answer to this seemingly simple question. At this very moment it is once again the subject of a particularly contentious debate, with the last major elements of international and European regulatory reforms in a decisive stage of negotiations.
The conditions under which the negotiations are taking place are difficult. On the one hand, the financial crisis with its enormous impact on nations’ economies and on the financial sector is still painfully remembered. On the other hand, the next set of challenges already have their foot in the door. Financial institutions and savers are complaining about the low interest rates, banks and savings and loans are struggling to maintain profitability, while at the same time they are being forced to adjust to a new digital market environment with new competitors.
In the end, it's companies and consumers that feel the sector’s problems in rising fees. So it is no wonder that no real consensus exists on the direction these still pending proposed reforms should take. In the eyes of representatives of the banking industry, the new rules represent overregulation and should be loosened. They primarily cite the higher costs that come with implementing and complying with the reforms.
On the other side are critical voices, often from academic circles, who consider the rules decidedly too lax. In their view, banking regulation should be even stricter and the banks’ equity ratios raised even higher to make future financial crises as improbable as possible.
Reforms are vital for a banking industry that not only wants to be profitable in the future but above all is meant to be stable.
Both views have factual and objective arguments on their side and deserve to be heard and discussed. This is how a consensus was reached in the wake of the financial crisis – coupled with the experience of deregulation in the lead-up to it – that a stable financial system needs stricter rules. And so the Group of 20 nations and heads of government introduced far-reaching regulatory reforms beginning in late 2008.
These reforms are vital for a banking industry that not only wants to be profitable in the future but above all is meant to be stable. The new rules determine in particular the amount of equity and how much liquid assets a bank must be outfitted with. They will make the banks less susceptible to crisis.
Even if a large portion of these reforms have already been finalized and also implemented, not all of the elements of the reforms could be worked out at the same time – the remaining elements still need to be finalized. That is the point we have now arrived at.
First and foremost it is a matter of closing still existing gaps in the negotiations over how minimum capital requirements are calculated, and regulators are also working full steam on perfecting additional measures of the reform package. As a result, far-reaching guidelines will soon be issued for banks as to how they must calculate their risks upon which, in turn, their capital adequacy requirements are going to be measured.
If the banks use their own models for calculating risk, they will to comply with stricter guidelines from supervisors in future – for example, ensuring minimum amounts for their modeled parameters. This is designed to prevent abuses in the use of in-house models that came to light during the crisis.
Equally subject to criticism is the regulation of real-estate loans. The demand here is that capital requirements, especially for loans to finance property, should be considerably tighter than to date.
The fact that real-estate loans must be backed by capital commensurate with the risks is not a matter of debate – after all, real-estate bubbles like the example seen in the U.S. subprime mortgage crisis can be a serious threat to the stability of our financial system – yet for German institutions in particular, the fears of trouble here are disproportionate, since in this country property risks are treated with particular care based on very strict rules on determining the value of real estate collateral. Given this, as well as our comparatively conservative standard of granting loans, it is no surprise that the rate of defaults on real estate loans in Germany has been statistically low over a longer period of time.
To make it quite clear, there is some excessive exaggeration going on here.
Perhaps the most important question remains that of the overall scale of minimum capital requirements. In other words, the question of whether banks should increase their equity capital even further or are already sufficiently capitalized.
The answer from banking representatives is unequivocal. They criticize the intended reforms as being too strict. In reacting to those calls, the concerns can be heard in the other camp that the rules will be loosened – not least of all in reaction to pressure from the banking lobby – and that this places the stability of the banking sector at risk.
However, a closer look at the status of the reforms show that such concerns tend to be unfounded. This is particularly true when not only the measures still pending are taken into account but also considered together with all of the reforms since the crisis.
Those calling for us to dictate even higher equity capital rations for banks and savings banks fail to understand the regulatory reforms already finalized and being implemented today. In the European Union, they include the Capital Requirements Directives and the Banking Union, and, on a global level, the voluntary regulatory framework of the Basel III Reforms of 2010.
Together, these rules have resulted in banks and savings banks today being required to hold larger and much higher quality of assets in reserve than was the case up until 2008. While German banks in 2008 only maintained a core capital of around 9 percent, this cushion grew to over 15 percent by 2016. This has notably increased the resilience of the banking sector.
A lot is at stake with the finalizing of the regulatory reform – not only for the financial institutions but not least of all for the German and European economies, as well. For that reason, the debate about it is so vital and objective criticism based on fact must be recognized and taken into account.
But in my view, the criticisms fail on many points to grasp the reality in which we live. Today, banks are holding considerably more capital, and of a higher quality, than just a few years ago. That has made them more stable.
The future regulatory framework should neither subsidize the banking industry by lowering requirements, nor burden it with disproportionally excessive demands.
The reform elements yet to be finalized are aimed at closing the remaining gaps and better correlating with each other the many individual parts of banking regulation, which have since become exceedingly complex. This is meant to make the regulatory requirements even more effective. But regulation is only one side of the coin. Ultimately, representatives of the banking industry are being urged to be objective. They are currently spending much too much time vociferously advocating for a weakening of the reforms.
The banks are playing a numbers game, pointing to the high costs of implementation as well as massive additional equity requirements, and fomenting fears of the institutes being placed under too severe a burden. As an additional means of ramping up the pressure, some are warning about a threatening credit crunch. To make it quite clear, there is some excessive exaggeration going on here.
But there also happen to be objective, plausible arguments that speak in favor of finding ways for the calculation of risks to be more reliably formulated, without at the same time continually increasing the capital requirements. Without doubt, the far-reaching reforms are accompanied by large burdens in their implementation that will pose a particular challenge to the institutions.
The banking sector is supposed to be stabilized by a strong set of rules, but it also should not be excessively constrained. For that reason, the Basel Committee on Banking Supervision, had set for itself a very ambitious timetable early on and specified that capital requirements were not supposed to increase on the whole too significantly. That way, in a demanding market environment, banks and savings banks should be given a better planning horizon from the regulatory side.
That is why I am convinced it is right and proper to proceed in finalizing the reforms with a sense of proportion. When the stability of the banking sector is at stake, we should drop the extreme positions and instead strive for a well-balanced set of rules.
The future regulatory framework should neither subsidize the banking industry by lowering requirements, nor burden it with disproportionally excessive demands. Only in this way can we attain the goal of obtaining and preserving a competitive but also stable financial system in the service of corporate and private customers.
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