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Ten years ago, the world faced the worst financial crisis since the Great Depression. Companies went bankrupt, thousands of people lost their homes as foreclosures skyrocketed on both side of the Atlantic, and the banks that were too big to fail, did fail - only to be then rescued to by billions of taxpayers’ dollars.
Governments and their financial regulators were caught completely off-guard and found themselves lacking the appropriate regulatory framework to lessen the repercussion of the crisis and to prevent it from spreading deeper.
While the reasons for the crisis were many, as were the culprits behind it, one sector was quickly pinpointed as the main responsible: the banks, or better yet the governments lack of regulations on its financial systems.
The collapse of Lehman Brothers, fourth largest investment bank in the US, due to its exposure to the sub-prime mortgage crisis, laid bare the risk banks were running in search of higher profits, risks than were going unchecked by the regulators up until the point it was too late.
However, this in itself was part of a larger process of liberalization that had started almost 30 years before the crisis, when governments started pulling back regulations from Bretton Woods era.
Before and After Bretton Woods
After the Second World War, the governments of the US, Canada, Western Europe, Australia and Japan negotiated a monetary order that obliged each country to adopt a monetary policy that maintained the exchanged rate by tying its currency to gold, and enabled the IMF to cover imbalance of payments. This would come to be known as the Bretton Woods system.
This system was in place until the 1970s, when a liberalization process started in most western economies that culminated with the Global Financial crisis in 2007.
It must be said, however, that even the 2007/2008 subprime mortgage crisis was not the only financial crisis from the post-Bretton Woods era: from the period from 1970 until 2007 the IMF counts a total of 42 systemic banking crises, both locally and internationally.
But it was not until the aftermath of the credit crunch that the leaders of the largest economies in the world arrived to the conclusion that the only way to prevent futures crises was to stop this liberalisation process and bring back tight regulations and government controls.
This also carried important political implications; the general public, enraged by bankers, was not going to stand and watch those they believed to be responsible for the crisis continue to go unsupervised; their trust in the financial sector was lost.
In a speech in Dublin this year Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, explained why tight regulatory standards were still needed even after ten years.
“After all, bankers are people. Like the rest of us, they sometimes tend to overestimate potential profits and underestimate risks. Markets can get carried away, as Alan Greenspan said, by irrational exuberance. Expecting eternal growth, banks might make huge investments. But at some point, reality hits, and it might hit hard. If it does, those who took on too much risk might fail. And the crisis taught us that the failure of a single bank can damage the entire financial system and the economy. In a nutshell, that’s why banks need rules.”
The New World Order
Today banks are heavily regulated, following the introduction of The Dodd-Frank Act, the Volcker rule, and the Foreign Account Tax Compliance Act (Fatca) in the U.S., and the Mifid II, Emir, Mifir, and Basel III accords in the EU.
Compared to earlier regulations, the Senior Managers Regime, Certification Regime, and Conduct Rules are also increasing the individual liability of senior bank managers.
According to Jonathan Weinberger, Managing Director of Debt Capital Markets at Societe Generale, “the regulatory community has completely rethought financial regulations since 2009. In 2010, we saw the first pan-European stress tests and Basel III, both of which were significantly different to prior practice and regulation. Banks globally have considerably increased the quantity and quality of their capital as well as their liquidity buffers, have built significant loss-absorbing buffers in the context of recovery and resolution frameworks, and have been compelled to rethink their risk appetite and therefore their business models as a consequence.”
Darrell Duffie a financial economist, explained in his report “The Financial Regulatory Reform After the Crisis” that while they share a common purpose, European and US authorities have taken different approaches when it comes to regulation.
“The US Dodd-Frank competition rules are narrowly aimed at the swap market. Europe’s Markets in Financial Instruments Directive (MiFID II) and proposed MIFIR implementing regulations are more ambitious in scope than the US reforms but are moving much more slowly,” the economist wrote.
Today, under the Basel III accords, a bank’s equity Tier 1 capital ratio is set at minimum 4.5% with a Tier 1 capital ratio defined at 6% and a minimum total capital ratio of 8%. To that, lenders will need to add a conservation buffer of 2.5% which will be need to set in place by 2019 as well as countercyclical up to 2.5%, while the leverage ratio is now set at 4% and the supplementary leverage ratio of 3%.
And this seems to have paid off, earlier this month the Federal Reserve conducted their annual stress test on banks, which produced very positive results on the US banking system. The test showed that the 34 institutions under assessment had enough capital to endure the two scenarios posed by regulators — one related to the financial crisis and another entailing a shallower downturn.
Under the simulation, the banks tested "would experience substantial losses." However, in total, the institutions "could continue lending to businesses and households, thanks to the capital built up by the sector following the financial crisis," the report noted.
The Federal Reserve also affirmed that the aggregate ratio of common equity capital to risk-weighted assets doubled from 5.5% in Q1 2009 up to 12.5% in Q4 2016 in the US.
The results on the European banking system will be released in December this year, the European Banking Authority announced.
The tests marked the third straight year the banks have all met the Fed's standards for health, which means as Mohamed A. El-Erian, Chief Economic Adviser at Allianz, wrote in an article published in the Guardian, “ongoing measures to buttress the global financial system have undoubtedly paid off, especially when it comes to strengthening capital cushions and cleaning up balance sheets in important parts of the banking system”.
The Regulatory Problem
The positive results of the bank stress tests might – for some people, including US president Donald Trump – enforce the idea that time for “excessive regulations” has now passed.
Even if the regulations have forced banks to boost their liquidity and keep leverage margins in check, some fear that too much regulation is killing the business, and question whether the current regulatory framework will indeed prevent another systemic crisis.
For Edward James, Director at RCQ Associates “the new regulations have put pressure on profits, mostly because it hiked the cost of business for banks’,” which, in turn, could pose a threat to the stability of the financial institutions in general.
Meanwhile, Andrew Breach, Global Financial Services Practice at Hoggett Bowers, believes that “excessive regulations” might prevent banks from doing the job that they need to do.
In 2013 (even before the full set of new regulations was in place) the six largest US banks spent an estimated US$70.2bn on regulatory compliance, doubling the US$34.7bn they spent in 2007, according to data compiled by Duffie in his report
For Weinberger, whether or not the regulatory frameworks currently applied today are effective is a topic “of evergreen discussion”.
“As one financial actor’s costs change – for example, because of regulatory pressures – the market typically responds by shifting the useful activity to another person or place. The shorthand is ‘shadow banking,' but what is lost in that static phrase is that the actors performing the economically useful activities change over time. Whether the result is the best mix of risk reduction, consumer choice, and fostering economic growth, it has to be constantly re-evaluated as the economy evolves.”
“What I find heartening is that we now have a concrete example of the SRB resolving a failing bank, and a significant one at that, with minimal market disruption. We note that on both sides of the Atlantic there has been a desire to have a fresh look at the post-crisis reform measures to assess whether they have appropriately achieved their purpose and ensure that they are not creating unnecessary hurdles to financing economic growth and job creation,” Weinberger explained
It is important to understand, especially now, as the debate shifts to whether or not the current regulations are still needed, that the current framework in place might not be enough to prevent another crisis.
“Another crisis can always happen again, but the new rules can make it less systematic,” James argued.
Weinberger maintains the argument that, while another crisis can always occur, it will vary from institution to institution from region to region, depending on the type of internal “risk models” used by each organization.
“The institutions most impacted will be those whose businesses are highly exposed to assets with modelled risk weights, quite different from the standard-approach risk weights. In addition to the difference between financial institutions, there are also meaningful differences between regions, notably in terms of the availability of alternatives to bank financing: in the US for instance, low-risk assets are financed to a far higher degree by capital markets and non-bank actors than is the case in Europe or Asia,” the banker explained
Ten years on from 2007, and with the global economy and financial institutions stable, the public debate has shifted to whether or not these regulations should be replaced – marking a return to a more liberal approach.
But while it is true that rules need to be reviewed and adapted to meet the requirements and conditions of the time we live in, it would be dangerous and short-sighted to simply discard or dispose of the current frameworks.
“The considerations arising from regulation tend to be strategic – as I said before, regulation is a key driver of whether businesses are viable – and as such is hugely important,” Weinberger concluded.
