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Basel should rethink proportionality in banking regulation

Guest contribution in "The Banker" on 03.01.2017

Andreas Dombret [+] Andreas Dombret

Wherever bank supervisors go these days, they hear the same two concerns: first, that the regulatory burden of post-crisis reforms has become far too heavy for banks to be profitable; second, that the pending Basel III reforms will make these burdens even heavier.

The complaints become particularly loud when I talk to smaller banks. Because rules have become highly complex, these institutions say that compliance has become a Herculean task for them, which makes it almost impossible to perform banking in a profitable manner.

And you know what? I do understand the banks. Actually, I would love to reduce the administrative burden that comes with highly detailed and complex regulations - not only, but especially, for smaller banking institutions. I believe the EU should take a closer look at what can be done to enhance proportionality in supervision and regulation for banks with low-risk profiles. Moreover, we should be giving systematic thought to this on the Basel Committee.

New approach from EU

There are two options for improving proportionality. The first is a detail-driven approach that involves introducing special exceptions or adjustments to individual rules. The European Commission’s review of the most important regulations is a welcome case in point[1]. Yet this may not be enough. A more radical approach would be to create separate rules, which simplify all or some rules for smaller institutions that have low risk profiles.

The EU should analyse both options very carefully. I can see a great deal of potential in the creation of separate regulatory frameworks for smaller institutions and large multinational banks. Such a fundamental approach is worth considering, since it would address - in a systematic manner - the excess burden placed on the operational capacities of smaller institutions.

A two-tier system could be put into practice through a graduated set of Basel standards for institutions that are neither multinationals nor large, with low risk profiles.

In this scenario, only systemically important banks - for example, the significant institutions in the euro area, which are supervised directly by the European Central Bank - would be subject to the fully loaded Basel III requirements, which could be implemented soon after being agreed upon in Basel.

This would be appropriate from a risk perspective: large banks would be regulated under a harmonised set of global rules, while smaller institutions and those operating within a given region would be governed by graduated rules that account for their different business models and risk profiles by setting less complex requirements.

Preconditions to change

There are two preconditions that have to be met by any alteration of the rules. First, the focus must remain on reducing the burden on operational activities - an easing of minimum capital and liquidity requirements is not on the table. Second, relief must never put financial stability at risk. Medium-sized, highly systemically interconnected institutions - those referred to as 'too interconnected to fail' - and those institutions with risky business models should not be given any relief.

Such separate rules for international banks would have a beneficial side effect for the Basel Committee. The potential for strengthening its commitment to restricting its standards to multinational banks would also help to unblock the sometimes-difficult deliberations about domestic banking market specifics.

For this, all participating members could agree to refocus the work of the Basel Committee on globally harmonised standards for large, internationally active banks. Basel regulations could then be differentiated and tailored to the size and the importance of the institutions: strongly recommended standards for global systemically important institutions; recommended guidelines for domestic systemically important institutions; while smaller, regional institutions would not be targeted.

Background to Basel

A cross-border level playing field for banks, made possible by globally harmonised regulations, has been the cornerstone of banking regulation since the 1970s, when financial crises became more frequent and took on an international dimension.

Since then, banking supervisors from around the world have been coming together in the forum provided by the Basel Committee on Banking Supervision to draw up global standards for the regulation of large, internationally active banks. The outcome of these efforts has been the introduction of highly welcome global regulatory frameworks: Basel I in 1988, Basel II in 2005, and the recent Basel III agreement.

From the outset, these rules were designed to supervise large, internationally active banks. In the EU, however, the prevailing political circumstances led to the rules becoming binding for all institutions: the Basel agreements constituted a politically acceptable compromise for regulating banks in the common market. Thus, the rule packages agreed in the Basel negotiations were not reopened while they were being implemented in the EU.

As a result, since Basel II and its implementation in the EU, we have detailed technical rules of risk-weighted capital regulation that apply to all credit institutions, even though these rules may be oversized for many smaller banks that operate regionally.

Against this background, in 2005 Basel II was a hard-won compromise - made possible as a result of many options available for smaller institutions (such as the standardised approaches for capital calculation). This compromise, however, has been shaken by the extensive regulatory reforms introduced in response to the financial crisis.

The rules have become so complex that it is more fitting for large, internationally active banks, while small and medium-sized banks are left with the administrative burden of complying with such rules without the advantages of economies of scale that come with institution size.

It’s complicated…

Since post-crisis reforms have been targeted at the central point of failure, they are directed at the regulation of large and internationally active banks. In essence, these reforms are all focused on optimising complex, risk-weighted capital regulation. This, in turn, facilitates the maintenance of large, internationally active financial institutions that optimise the allocation of scarce capital.

Two other possible options would have been either to increase capital requirements substantially, thereby making regulatory control of risk measurement less important, or placing restrictions on the model of big banks, for example, by separating depository institutions from other activities or introducing size limits. In the absence of such alternatives, substantially improving the risk-weighing approach has become crucial.

For international banks, this approach has been beneficial, as it is consistent with their size and business model. For smaller institutions, however, the political situation described above (through which rules are applied to all institutions) means these regulations have come to pose a major challenge[2].

Put simply, the problem is that we devise rules to control large, internationally active banks, but that these regulations also end up applying to smaller, regionally orientated banks. This is problematic, because it has an unintended effect, namely fostering the 'too big to fail' phenomenon. And it weakens a competitive banking sector with many banks of different types and sizes.

For that reason, I firmly believe that we should analyse carefully how we can go about redressing the balance. We need an agenda for the EU and the Basel Committee.

Global rules, regional rules

When reflecting in our times on the costs and benefits of global co-operation, it is important to stress that one is not against globalisation: the Basel standards are very welcome when it comes to supervising large, significant financial institutions. But a key question is whether such standards represent a one-size-fits-all approach, and this has become even more important, as the complexity of regulations has increased so much in the context of post-crisis reforms.

Global economic co-operation in itself is neither a good nor a bad thing. It serves a purpose, and it is reasonable to ask whether that purpose is best served by global standards that were designed for internationally active financial institutions being applied to smaller, regional banks, or whether this constitutes over-the-top harmonisation.

A rethink is called for. To this end, the EU should give careful thought to the viability of a separate set of rules for smaller, regional institutions with low risk profiles. At the same time, the Basel Committee could refocus on large, internationally active banks.

Banks of different sizes are vital to a banking sector that serves the real economy. A more differentiated system of rules could serve this purpose well: I am all for it.

Footnotes:

  1. On November 23, 2016, the European Commission submitted to the European Parliament and European Council for their consideration and adoption legislative proposals to amend the Capital Requirements Regulation, the Capital Requirements Directive, the Bank Recovery and Resolution Directive and the Single Resolution Mechanism Regulation.
  2. Two qualifications are in order: first, these new rules and their higher capital requirements are highly challenging for large, internationally active institutions as well; second, post-crisis reforms are already proportionally upward, stipulating more stringent requirements for (global) systemically important institutions. Such limitations notwithstanding, there is a firmly established general trend of rules becoming more complex for all banks, and being more challenging for smaller ones.

Additional information

The Author

Dr Andreas Dombret

Contribution by Andreas Dombret,
Member of the Executive Board of the Deutsche Bundesbank

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