The future of banking regulation

The City of London released an interesting document yesterday on the future of regulation of banking. They talk about liquidity, leverage, capital and risk liberally, and state that the future regulatory regime must not clamp down on capital reserves in banking so hard that the banks are unable to lubricate the global economy.

What I found interesting is that there are quite a few contradictions in the 77 page report although, to be honest, I only read the Executive Summary.

From this summary, it’s interesting that they plead that the macroprudential structures don’t squeeze capital ratios, but hardly talk at all about the leverage issues Lehman Brothers created.

If my memory serves me, Lehmans was operating at leverage ratios of up to 1:40, e.g. for every $1 of capital, $40 was being used to ‘gamble’ on the global markets. I also remember that their debts at bankruptcy were around $400 billion and BarCap estimated that for every $1 of debt, around $20 of Credit Default Swaps were being leveraged against Lehmans AAA rating. In other words, $8 trillion of leverage was in the system off the back of Lehman Brothers.

That was the issue, particularly when this leverage – and therefore liquidity – disappeared overnight.

Following on from this, they refer to the fact that the crisis was not caused by a lack of capital, but by a lack of liquidity. True, but I did not gather a clear view on liquidity risk or leverage ratios from the document. It may be in there, but it’s hard to find.

For example, in Section Five that addresses Leverage Ratios, the report states that “judgement and discretion are vital, including judgement and discretion concerning circumstances under which firms will be permitted temporarily to have capital that is inadequate. The notion of employing a leverage ratio as a last-resort backstop to limit the damage caused by regulatory get-arounds arises precisely because of the limited ability and appetite of regulatory authorities for exercising discretion. That core problem is the one to address.”

A bit of fudge if you ask me there.

The same is true on liquidity risk, with the report proposing a global liquidity standard and yet they then say that they are “unconvinced that there is a case yet made for pursuing significant further deepening of international coordination of banking regulation. Indeed, we believe it quite likely that greater exercise of national discretion is the appropriate path forwards.”

Now I understand the conundrum that you cannot have one nation regulate for example to stop bank bonuses as it will just mean bankers jump across to other nations. So you need a global agreement of some form. Equally, no global agreement will work, as there is always gold-plating and protectionism of national instruments, so you need a global framework with local interpretation.

That is kinda what they’ve proposed, but it’s rather unclear. For example, their closing comment on liquidity is:

“In our view, improving liquidity standards are amongst the most important and material changes to be introduced — though they are likely to have high costs that must be recognised. However, the scope for international standards to deliver adequate liquidity is limited without increased roles for national lenders of last resort and in particular an increased role for central banks in prudential supervision.”

In fact, the regular mantra in the document appears to be the frictions and tensions between global and local. For example, they state that there is a “risk that regulation will not apply evenly or that regulation will apply in the UK before the rest of the world”, and that this “is seen as a significant threat to London’s competitiveness. It is therefore widely urged that the Basel measures enact a common international timetable. International firms that operate in multiple markets are particularly keen to see common, consistent frameworks and standards applied.”

Yet, as mentioned, they don’t think regulation will or can be applied consistently across multiple markets.

All in all, more questions raised than answers in this document, but worth a read for those who are technically minded and interested.

Download available from the City of London's website.