Commentary

Peter Burgess

Reforms: Banks locked in vicious circle as regulators debate tougher rules

After faint hopes last year of a sustained global economic recovery, it is clear that a second leg of the financial crisis, three years after the first one peaked, is dispelling hopes of anything better than stagnation for the years ahead.

At the centre of that dynamic are the world’s banks – the cause of the woes of 2007 and 2008 and now, in large part, victims of a “feedback loop”, as the cost to governments of funding state bail-outs compounds underlying economic woes. With so much of that now shaky-looking government debt in the hands of banks, particularly in the eurozone, a vicious circle has developed that is proving all but impossible to break.

The surprise is that after more than 12 months of fairly sustained pressure on the weakest parts of the eurozone periphery, more banks have not collapsed. Aside from a part-nationalisation of the Irish banking system, most banks have survived.

Regulators – midway through implementation of reforms drafted in the wake of the 2008 crisis – are adamant that without the drive to toughen capital and liquidity requirements there would have been more victims.

But a row is raging about how much further banks need to go to protect themselves from the latest woes. Is this the time to beef up buffers? Or, in the midst of a crisis, should regulators be letting banks eat into reserves – the so-called counter-cyclical strategy. The markets are clearly torn. Credit Suisse, for example, had outperformed rivals on the stock market thanks to strong capital buffers, but has slumped recently, as fears mount that generating sufficient returns on those higher equity levels will be tough.

Yet, at the same time, France’s banks became the butt of the sell-off of eurozone banks, because of a combination of relatively high exposure to the Greek economy, compounded by slimmer capital buffers than most European rivals.

Christine Lagarde, the new managing director of the International Monetary Fund, made waves when she said there should be “urgent” recapitalisation of European banks, to allow them to take the proper writedowns on the value of troubled eurozone debt, in preparation for possible defaults.

Within a fortnight, Jamie Dimon, chief executive of JPMorgan, had added his polar-extreme view, describing as “anti-American” the new Basel III global rule book on capital and liquidity. The US should consider pulling out of the agreement, he said.

Yet it seems certain that banks everywhere will have to hold higher levels of capital and liquidity – slashing profitability from the pre-crisis norm of 20-30 per cent return on equity to more like half that, at best.

But regulators should go further, says Andrea Enria, head of the European Banking Authority, the oversight regulator for the European Union. “[Extra capital] is extremely important,” he told a recent Financial Times breakfast debate on the Future of Banking. “But it’s important that we strengthen supervision. I think we have a major task ahead in dealing with [systemic risk].”

The concerns apply as much to the so-called “shadow banking” environment of hedge funds and money market funds as to banks themselves, as tougher rules for lenders push business into less regulated institutions.

Some countries are going further than the baseline global norms set by the Basel Committee of regulators. On September 12, the UK’s government-appointed Vickers Commission recommended sweeping changes to the structure of the country’s banks. In a report backed by the government, with legislation promised by 2015 and implementation by 2019, so-called universal banks operating in Britain – with retail and investment operations under one roof – will have to separate those businesses with a “ringfence”.

The idea is that barring the use of high-street deposits to back investment banking will make the businesses safer. At the same time, it will remove in the UK the kind of implicit government guarantee that has existed in many countries since institutions from Northern Rock to Commerzbank were bailed out three to four years ago.

Most bankers and regulators believe the structure will remain a British preserve, with other countries adopting their own reforms.

More regulation is coming, though, with the Basel Committee yet to rule on the exact liquidity requirements that banks should hold for the short term, and also on the maximum mismatch that should be allowable between short funding terms and long lending commitments. Everyone has their fingers crossed that Europe’s banks can make it through the current malaise without those additional safety measures in place.

Copyright The Financial Times Limited 2011. You may share using our article tools.