Banking’s new era of capital puts watchdogs on the spot

THE 16th anniversary of the collapse of Lehman Brothers has been marked by regulators signalling that the era of toughening up capital rules is over. The strength of banks and standards of safety have been significantly bolstered since 2008.

From now on, what matters is that supervision is well-funded and rigorous so that none of this is undermined or chipped away in the years ahead. Be warned: the pressures of competition in finance and myriad other calls on government funds make this no certainty. 

Last week, the Federal Reserve’s top rulemaker, Michael Barr, watered down the US’ proposed version of the global Basel 3 standards, slashing demands for extra capital at the biggest banks by half. His climbdown followed a bruising backlash from industry and Congress over the past year.

There were lots of problems with the Fed’s initial proposal, but Barr’s humbling was unusually harsh. And it may not be over yet. Big banks are likely to push for further changes and have threatened lawsuits if the end result is still tougher than they want.

Pushing back

The initial 2023 proposal projected average increases in capital requirements of almost 20 per cent for the biggest banks. Barr has cut that to 9 per cent, but the banks want at most a 5 per cent rise.

At the Bank of England, rulemakers finalised their version of the standards last week too; they’re expected to result in an aggregate increase of less than 1 per cent. The previous estimates of 3 per cent were reduced after a much quieter campaign from UK lenders than the US witnessed.

In a sign of things to come elsewhere, international competitiveness was a key justification for British regulators walking back some of their demands. 

In the European Union (EU), full implementation of the bloc’s final rules is expected to eventually lift capital requirements by 9.9 per cent. However, the EU is delaying the start date for investment banks’ trading desks so that local players don’t lose ground to US and UK banks, which won’t have to start meeting the rules until at least a year later – as things stand.

Even with this backtracking, the importance of the rounds of argument, testing and negotiation over much of the past decade has been about fixing technical details of how risks are assessed and ensuring that the largest, most sophisticated banks don’t get too great an advantage over their smaller peers (or over their regulators) through overly clever modelling.

Most of the heavy lifting of shoring up bank balance sheets was done – and most of the extra capital requirements imposed – in the years immediately after the 2008 crisis. There is no magic number for how much capital banks should have, and there will always be voices that demand more.

Academics and campaigners are right to say that the more the equity issued by banks, and the less leveraged banks are, the safer they will be and the cheaper their equity should also be. However, this will still ultimately increase the cost of borrowing because banks’ total funding costs will rise.

That’s because lower leverage won’t do much to cut the cost of banks’ own borrowing. Unlike other kinds of companies, banks already pay very little and often close to zero for most of their liabilities, which are ordinary deposits.

The only way to make banks (and deposits) truly safe is to split the business in two: Move to a world of narrow banking, where deposit holding and payments services are completely separated from the business of making loans to companies and households. But there are insurmountable problems with that model, in my view.

Stronger supervision

In the world as it is, at the end of a cycle of adding to prudential buttresses, the role of supervision becomes much more vital. This isn’t just about ensuring that banks and their staff understand and adhere to the standards; it’s also because the longer a given set of rules is in place, the more that smart and motivated people will find ways to maximise the risks that can be taken and profits that can be made within them.

Unfortunately, there have been signs that supervision is already a weak point in the system. In the US, the collapse of Silicon Valley Bank in 2023 was first and foremost down to bad management – but the errors of exposure, hedging and leadership were allowed to persist by weak oversight.

Nothing in the capital-rule changes, either as initially proposed or as watered down, would address the danger of SVB’s large portfolio of low-yielding hold-to-maturity Treasuries and agency bonds. Oversight has to improve.

The management failings that led to the implosion of Credit Suisse last year were abetted by Swiss supervisors with minimal powers of intervention. In the EU, a lack of resources led to a botched review of risky buyout lending, which has knocked the reputation of the watchdogs.

Proper, regular scrutiny of banks is hard and costly. It requires good data and well-trained, knowledgeable staff who are paid well enough to not be regularly poached by the industry they are overseeing. And if it works, the sole thing most people will notice about it, unfortunately, is the cost.

But now that the post-2008 capital rules are all (mostly) finally settled, supervision is where the money and effort must be directed for the decades ahead. BLOOMBERG