When the end came for Lehman Brothers, it was all over within a few hectic hours on a frantic weekend in September 2008.
But when it comes to putting in new rules to make sure no bank can ever again push the world economy into financial Armageddon, that work has been going on for three years – and counting. Innumerable meetings of regulators, policymakers and central bankers have been held since the Group of 20 nations pledged to reform financial regulation in November 2008.
However, the end – or at least the beginning of the end – seems to be in sight. Proposals on new rules in a range of areas will be top of the agenda in the run-up to the November G20 leaders’ summit in Cannes.
While many experts fear the reforms have been watered down and will be introduced too late to prevent another crash, others believe they are being brought in at exactly the wrong time in the economic cycle. Just this month the UK’s Independent Commission on Banking recommended forcing banking giants to ring-fence their retail operations from risky wholesale operations, but to delay implementation until 2019.
In the US, the world’s largest financial market, progress seems to have stalled after the passing of the Dodd-Frank bill aimed at delivering root and branch reform. “There was a rush to have a Dodd-Frank bill passed either because of anger at the financial system or a need for retribution,” Myron Scholes, a Stanford University professor emeritus who won the Nobel prize for his work on pricing financial derivatives, tells Emerging Markets .
“Whatever the reason, we produced a 300-page bill without any regulations and, as a result of that, it is impossible for anyone in the financial system to know what the evolution of rules will be, and that means more disruption for the economy.”
The organization that has to juggle these competing pressures is the Financial Stability Board (FSB), a group of policymakers, regulators and central bankers, tasked by the G20 in the wake of the Lehman collapse to rewrite the financial rules. The FSB has taken on a huge agenda, covering everything from accounting standards to underwriting mortgages.
The main progress so far has been in agreeing proposals to impose requirements on banks to hold a higher amount of capital in reserve to enable them to withstand shocks. It will raise the amount of capital banks need to hold as a share of their risk-bearing assets from 8% to 10.5%. Within that there is a higher amount that needs to be held as tier one capital, and in particular as core tier one capital (common equity and retained earnings).
TOO BIG TO FAIL
Meanwhile banks deemed systemically important financial institutions (Sifis) – or too big to fail, in popular language – are already set to bear higher requirements under proposals going to the G20. These 28 institutions will have to hold an extra share of tier one capital, ranging from 1% to 2.5% depending on their systemic importance.
The FSB has set out a series of criteria that will be used to decide each bank’s surcharge, including balance sheet size, the scale of cross-border claims and liabilities, its reliance on wholesale funding, and the amount of lending it does to other financial institutions. Banks at the top end of the range that then increase their systemic importance further would have to take on another 1%, taking their burden to as high as 14%.
Under an agreement signed by G20 leaders, the new framework will be translated into members’ national laws and regulations, implemented in January 2013 and fully phased in by January 2019.
On top of that is a liquidity coverage ratio that would require banks to hold enough easily-sellable assets to withstand the 30-day run on funding that brought Lehman down. This is targeted to come into effect in 2015.
The banking industry has been vociferous in its attack on the regulations, warning that moves to accelerate the implementation would wreak economic havoc at a time when the recovery is faltering.
Earlier this month the Institute of International Finance (IIF) produced a 130-page analysis claiming the proposed reforms would leave global GDP 3.2% lower than it would otherwise have been. Even that is only an average figure, with predictions that countries such as the UK, which is proposing tighter capital requirements and liquidity ratios, will be severely affected. The IIF forecasts that UK GDP would be 5.5% lower.
It warns that bank lending rates would be 3.6 percentage points higher, bank capital requirements would amount to $1.3 trillion while 7.5 million fewer jobs would be created. It says it accepts regulatory reform needs to be put in place but says policymakers are failing to take account of the severe economic downturn and instability in the financial markets this year.
Charles Dallara, IIF managing director, says: “The leading questions throughout this crisis have been: are we getting the balance right and do we understand what the macroeconomic implications of the layers of regulatory reform are? We are not sure that balance has been found.”
While he supports the original timetable to implement capital requirements by 2019 as “broadly warranted”, he accuses regulators of adding extra layers. “The question is whether, in addition to those measures, it makes sense to add additional layers in the form of taxes, of surcharges for supposedly systemically important institutions, of liquidity provisions that have yet to be adequately sorted out, and of additional national measures specifically in the US and UK, which add further burdens to financial institutions,” he says.
“If there’s a desire to have a global level playing field to strengthen our institutions then let’s do it on a consistent global basis. Let’s put Basel III in place, but let’s not throw additional weight on the banks.”
His deputy, Phil Suttle, says there is evidence that obligations on banks to hold more government debt are contributing to the instability in the euro sovereign market.
“Advocates of reform say we are going to get tremendous stability,” he says. “What is going on in European debt markets is an illustration of some of the instabilities that can be introduced if you require banks to hold too much government debt.”
This point receives some support from independent experts. Roger Myerson, a Chicago professor and Nobel laureate, speaking to Emerging Markets at the 4th Lindau Economic Meeting in Germany last month, criticized Basel rules that give a zero-weight risk to government bonds but the largest weight to unsecured loans.
“One thing we want from our banking system is to provide small and medium-sized businesses with expert oversight,” he said. “Regulatory rules that favour government debt over loans to private business have the effect of siphoning our savings away from small and medium-sized businesses.”
While the low level of lending to small companies is a highly political issue, critics believe higher capital requirements will have other negative knock-on effects. One concern is the need for private equity houses to refinance an estimated $857 billion of debt at a time when banks will need to divert resources towards building capital reserves and away from new, risky lending.
“It’s a fairly simple story,” says Mark Kalderon, partner in the financial institutions group at law firm Freshfields Bruckhaus Deringer. “It’s going to be difficult for the banks to meet the whole of this refinancing burden.”
Some economists believe the capital requirement plans do not go far enough. Bill Sharpe, a fellow laureate and a professor at Columbia University, says banks have “just got to have a lot more equity capital.
“We can talk about the percentage, but I am convinced that it is a lot larger than even the high numbers that are being bandied around and a lot larger than some of the numbers we have seen in the US.”
Myerson disagrees, saying 8% sounded “like the magic number... a capital requirement of 20% would make it difficult to prevent a shadow banking system from becoming the dominant form of banking that would be more difficult to regulate.”
Some of the messages may be getting through to policymakers, who are rumoured to be considering weakening the liquidity requirement.
BREAK-UPS
Meanwhile banks and politicians in the US and UK continue to slug it out over the idea of breaking up banks that are too big to fail.
Myerson says the answer could lie with clever use of requirements as economic incentives. He says larger requirements for too-big-to-fail banks give them an incentive to divest subsidiaries, which is preferable to forcibly breaking them up. “They can be incubators of new businesses, but once they get a business going then if its capital charge would be less if it became an independent entity, that gives an incentive for banks to spin off subsidiaries and create more competition in the banking system,” he says. “I am a Chicago economist so I look for a price way of doing it.”
An equally thorny problem is how to improve the capacity of authorities to resolve failing Sifis without systemic disruption and without exposing the taxpayer to the risk of massive losses. “I am sympathetic to the idea that a bank that’s too big to fail is too big to exist and we should bust them up,” Sharpe says.
The real danger is a repeat of the disorderly collapse of Lehman Brothers that would inflict painful costs to the financial system and the global economy in the absence of powers and tools for dealing with the failure of a Sifi.
FSB policymakers are calling on the G20 to approve an obligation on banks to write “living wills” – pre-written plans for winding the business up – by the end of 2012. Governments will be expected to create special resolution laws tailored for banks. Currently only five countries, including the US and UK, have them.
But even in the US there are concerns that the bankruptcy rules are still not fit for the purpose of handling the disintegration of a Sifi. Scholes describes the current bankruptcy arrangements as a “black hole”, saying the idea of settling 2.5 million contracts with collateral posted against them over a weekend is “virtually impossible”.
“That lack of information is just gigantic. We need a new infrastructure and a regulatory system that allows the financial system to be unseized,” he says. “We need to think how to change the bankruptcy rules to make it more effective. In the US it is effectively a black hole.”
While these issues dominate the debate over the remaking of the regulatory landscape, they are only the tip of the iceberg. The FSB is also drawing up proposals on regulation of shadow banking, credit ratings agencies, over-the-counter (OTC) derivatives trading and accounting standards among many others.
Set against the backdrop of the weakest economic outlook and greatest financial instability since the last days of Lehman, policymakers will be under pressure to ease up. But, many politicians will doubtless say it is the very memories of the collapse of the US banking behemoth that should spur them on to building a new financial architecture.