G20 and Reforming Banking Regulation

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The communiqué for the latest G20 summit is available here. It contains lots of the usual waffle about co-operation on this that and the other, but I think the most important element of the discussions relates to the reform of banking regulation.

The communique’s references to reforming executive compensation will probably attract the most attention. Reforms of this type are a good thing though I suspect that getting them implemented in practice may be tricky. More important, I think, are the proposals to reform capital standards. The relevant extract from the communiqué is as follows:

The national implementation of higher level and better quality capital requirements, counter-cyclical capital buffers, higher capital requirements for risky products and off-balance sheet activities, as elements of the Basel II Capital Framework, together with strengthened liquidity risk requirements and forward-looking provisioning, will reduce incentives for banks to take excessive risks and create a financial system better prepared to withstand adverse shocks. We welcome the key measures recently agreed by the oversight body of the Basel Committee to strengthen the supervision and regulation of the banking sector. We support the introduction of a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration.

All of these are good ideas but the proposals are completely lacking in specific details as to how exactly they would be implemented. There is a bit more information in this background document prepared by the Financial Stability Board but not much. The absence of specifics suggests that the hard negotiations lie down the road.

Take the leverage ratio for instance. Some of the financial institutions that had substantially over-stretched themselves prior to the current crisis were ostensibly well-capitalised according to the Basle risk-weighted-capital standards. However, it turned out that many of their investments were far riskier than had been understood and when things went wrong, they ended up undercapitalised or insolvent. A maximum leverage ratio acts as a sort of “backstop” (Lord Turner’s phrase) to the risk-weighted capital ratio: Given an amount of equity capital a bank holds, this ratio sets the maximum size for total bank assets, independent of how risky the assets are. Whether this is an effective tool in preventing banks getting into trouble depends on the size of the ratio and, of course, on the specific definition of capital used in the denominator.

Perhaps unsurprisingly, former IMF Chief Economist Simon Johnson isn’t impressed, viewing the Europeans as likely to be foot draggers in this process, and thus hindering rather than helping the process of raising capital standards in the US. He links to a similarly sceptical piece from Joe Nocera of the New York Times.

On a related issue, I have been appointed to the “Monetary Experts Panel” which briefs the European Parliament’s Monetary and Economic Affairs Committee in relation to its Monetary Dialogue with ECB President Trichet. Last week, I submitted a briefing paper on “The ECB’s Role in Financial Supervision” which discussed some of the challenges associated with macro-prudential regulation in Europe. It and some other papers submitted to the committee are available here.

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11 Responses to “G20 and Reforming Banking Regulation”

  1. Donal Byard Says:

    Karl

    The G20 won’t provide details regarding specific regulatory changes, they make policy recommendations that are then picked-up and implemented by the financial stability board, the BIS and the International Accounting Standards Board, etc

    The Turner Review is a report put out by the FSA in the UK last Spring. It has some specific details about how counter-cyclical capital provisions would work. It mainly picking up on the statistical model the Bank of Spain has been using. These sorts of counter-cyclical capital buffers would, however, make it easier for banks to manage their earnings (massage the accounting), so securities regulators will have some reservations.

    Another idea is to set-aside retained earnings over the cycle so they can’t be paid out in dividends in the good years. You could call this an economic cycle reserve.

    The biggest change from an Irish point of view might be moving away from the incurred loss model for loan provisions (wait until the crash to start setting aside provisions for losses) to an expected loss model — if this comes. The International Accounting Standards Board is already working on this. I don’t think they have a specific proposal up yet, but its on their agenda.

  2. Eoin Says:

    @ Karl

    surely the best way to address the banking sector vulnerabilities is to look at the developed world banking sectors which DIDNT get into trouble, ie Spain, Canada, Australia. Ok, the Aussies didnt even have a recession, so may not be able to glean too much from them, but the Cannucks and the Spanish surely have some good ideas, namley the counter cyclical reserve buffering of Spain and the mandatory mortgage insurance of the Canadians. I’m no regulatory expert, but this seems a very sensible place to start the discussion.

  3. Enda Says:

    Congrats on the appointment, Karl.

  4. Pat Donnelly Says:

    All to the good except that it cannot be implemented until the “crisis” is over!

    So just wallpaper really designed to instil confidence into a system that was bad and deliberately made worse by insiders to shear as many sheep as possible.

    On Nama, a much more important point since the Irish government will drive a horse and four through the best rules in the world, whenever it wishes, there is an interesting possibility that requires a courageous President. A. 13 of the Constitution. The power to dissolve Dail Eireann. Reserved to Mrs Mary McAleese on the advice of the Taoiseach. It is her power, not BIFFO’s! She can decide to call the election. For a debt the size of Nama, I truly believe she should. If the new Dail passes someting similar then refer to the S Ct.

  5. Alan Reynolds Says:

    @Eoin

    The Aussies avoided recession by having a big stimulas package and tight regulation of its banks . The banks here ( Australia ) have lobbied intensively against these regulations and successive governments have said no .

  6. Eoin Says:

    @ Alan

    is there any specific regulation which you think helped the Aussie banks stay out of trouble? As i said, i think it should be easier to find regulatory strengths in those that avoided trouble rather than weakness in those that failed, given that SO many different regulatory regimes seemed to be caught out in this whole mess.

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  8. karl deeter Says:

    the issue isn’t one of ‘regulation’ it is rather that of enforcement, we have plenty of rules, they just aren’t enforced.

    now we say ‘lets copy the canadians on regulation, the spaniards on capital provisioning’ and yet we don’t copy anybody on enforcement, in fact, that is the single unifying inadequacy across all regulatory bodies, they fail – far too often – to punish early and often, instead waiting until we have massive issues that result in huge failures (Bear Stearns/Lehman).

    so make all the laws in the world, they aren’t worth a penny if nobody enforces them, we’ll just end up with a lame duck who touts a bigger rule book around.

    regulators need inspectors and regular inspection of regulated firms, it has nothing to do with ‘new ways of doing things’ it just means stepping out of the comfort of Dame St. and out into the covered firms.

  9. Garo Says:

    For once I find myself agreeing with karl d.

  10. Alan Reynolds Says:

    @ Eoin ,

    Sorry I am not a economist or in finance and this is not politics.ie so I will not offer my opinions on Australian banking regulations . Except to say that the big four banks are always lobbying the government to relax the regulations and the 4 piller policy and the government keeps on saying no . The smaller banks also cry to the government about the big four as they ind it harder to compete with them .

  11. Alan Reynolds Says:

    I am a different Alan Reynolds — the American one that advised Australia to halve the capital gains tax rate in 1999. But I suspect this Alan is right too.

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