Defining “strong regulation” for safe banks

In an interview with Welt am Sonntag last week, ECB Executive Board Member Sabine Lautenschläger argued that strong bank regulation leads to strong banks. US regulators would agree but have a different definition of what strong means. We evaluate a range of positions to see if there is common ground.

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In her interview, Lautenschläger responded to her interviewer’s point that “profitable US banks are leaving European banks behind.” She said:

I find that idea quite amusing. Conversely, it means that the weaker the supervision, the stronger the banks. The truth is that strict supervision leads to strong banks. Institutions become more resilient when supervisors require them to hold adequate capital to cover their risks and insist on sufficient liquidity and better risk management.

US regulators agree, but have also been spending considerable time lately refining bank regulation to make it more applicable to the entities in question. For example, selected rollbacks on regulatory requirements for smaller banks are meant to allow those institutions to spend more time making loans and less time filling out regulatory oversight documentation. Many US regulations were already above the Basel III standard already, hence the rollbacks are supposed to make the playing field more equal.

Applying regulation to purpose and context is difficult. Basel III was always heavy-handed, and penalized Asian and emerging market banks that had nothing to do with the Global Financial Crisis. Europe started later than the US to solve its structural problems including allowing non-performing loans to stay on banking books. Meanwhile, a fast US bailout of banks led to growth restarting faster, the enactment of Dodd-Frank, and now the return movement of the pendulum towards less regulation.

Lautenschläger says that “we need to have the new Basel rules implemented in all major financial centers.” The largest banks around the world still play by different rules, and there seems to be no way to generate the single consensus that Lautenschläger would like. As examples, European regulators are considering asking European banks to calculate their Leverage Ratios daily rather than at end of quarter. This would make the rules equal for US, UK and European banks. At the same time, recent US regulation allowed custody banks to exempt certain central bank holdings on their balance sheet from the calculation of the Leverage Ratio. Everyone involved in each process often uses the words “strong regulation” in their explanations about rule changes; the difference is the conceptual understanding of what strong actually means.

Differences about strong regulation continue across US and European regulators and industry groups, and dissent about the direction of regulation is easy to find. The New York Times recently cited Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, as saying “The question is not: How do banks perform when the economy is strong? The question is: How do banks perform if there is a major economic downturn? And our analysis at the Minneapolis Fed says that the banks are still too big to fail.” The Minneapolis Fed plan advocates a 15% Leverage Ratio and a 1.2% tax on secured financing.

Every bank professional we speak with has their own opinions that European regulations are convoluted and, aside from the Liquidity Coverage Ratio, have not produced the result that European regulators sought. In a February 2018 Finadium survey report, European banking professionals said that “The LCR was seen as better than the Leverage Ratio due to its lack of penalties for High Quality Liquid Asset (HQLA) transactions, whereas the equal weighting in the Leverage Ratio was viewed negatively. The SFTR, Asset Encumbrance Ratios, and the NSFR all rated about a 2 on our scale of 1 to 5, and Financial Transaction Taxes (FTT) were seen as entirely ineffective.”

We don’t see a global solution soon to the question of what makes strong regulation and hence a safe bank. Basel III made great progress but still was not able to be all things to all banks and regulators around the world, leading to hundreds of exceptions and adjustments. When regulators trust each other, they can safely regulate banks in each other’s jurisdictions under the concept of equivalency. In that case, strong regulation can be defined differently but all agree that the home country’s definition means something. A decaying of trust and confidence, reflected in both the political and regulatory spheres, suggests a greater likelihood of financial zones of activity where banks must meet local definitions of strong regulation regardless of their home regulators’ opinions.

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