Banking Regulation

Author: Ronald Fink

The globe’s financial systems are still vulnerable to contagion. Critics say regulators are unlikely to fix the problem unless they shift gears.

Although many big banks have been bailed out, recapitalized and returned to profitability, the global financial system remains fragile six years after what some refer to as the Great Financial Crisis (GFC) brought the world to the brink of depression. The primary reason is that financial institutions are subject to market risk, the result of their dependence on capital instead of cash reserves. And their continued interconnectedness, reflecting the credit they extend to one another for short-term funding and the correlation among their assets, doesn’t help matters. Nor does the so-called “shadow” banking sector, which continues to expand unabated.

To be sure, banks are on more-solid ground than they were six years ago, thanks in part to regulatory reform under the international banking regime Basel III. A large part of that reform has involved the raising by banks of more, and stronger, capital.

According to the latest Global Financial Stability Report by the International Monetary Fund, the majority of a sample of more than 1,500 banks identified by SNL Financial as “advanced economy” banks now have Tier 1 common capital, which includes common equity, retained earnings and certain preferred stock, equal to at least 8% of their assets, whereas only a minority had that much in December 2008.

The improvement is most dramatic in North America, where more than 90% of those financial institutions now have at least that much Tier 1 common capital, compared with fewer than 10% six years ago.  More than 90% of the banks sampled in the euro area also have Tier 1 common capital of at least 8% of assets, whereas fewer than 30% had that much in December 2008. Lesser but similar turnabouts in capitalization have been seen at sampled banks in the rest of Europe and the Asia-Pacific region.

Euro area banks could see further improvement in their capital positions soon, as the latest round of stress tests by the European Central Bank show that some would not stand up well to another crisis.

The IMF did not report data for emerging markets banks, but experts say they pose little systemic risk, because they’re considerably smaller than banks in developed markets and engage to a much lesser degree in derivative transactions. In addition, regulators have more timely data on their assets.

“Under Basel III, it is safe to say that banks are in a better position now, compared to where they were before the GFC,” Amando Tetangco, governor of the Bangko Sentral ng Pilipinas, says.

But Tetangco concedes the global bank reform agenda “is not yet complete.” He says elements of that agenda have been defined under Basel III, but various measures have yet to be implemented. Those, he explains, are aimed at expanding what he calls “the regulatory writ” to shadow banking, which consists chiefly of investment funds and other largely unregulated intermediaries whose risk-taking is seen as a threat to those banks with whom they do business; at enhancing the infrastructure for over-the-counter derivatives; and at avoiding “too big to fail” situations. Tetangco says that “significant progress has been achieved toward stabilizing the financial system.” But, he adds, “we need to continue to pursue the reform agenda.”