The financial crisis triggered a revolution in banking regulation, but it is too soon to tell if banks have been truly tamed

They might not have been responsible for selling the dubiously repackaged sub-prime mortgages that were at the root of the 2007-8 financial crisis, but all the same, regulators rightly took a lot of the blame. The United States Financial Crisis Inquiry Commission (FCIC), which produced a comprehensive report on the causes of the crisis, said that while there was a “systemic breakdown in accountability and ethics” among lenders, it was regulators that let them get away with it. “The sentries were not at their posts,” the FCIC said.

No surprise, then, that the past five years have brought a wave of new financial regulation, aimed in particular at banks, which is designed to ensure that the financial system cannot implode again.

In the US, the monolithic Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010. It is intended as a catch-all: 848 pages covering financial-system oversight, bank capital requirements, executive pay, investor protection and many other issues, plus a range of miscellaneous regulations thrown in – including disclosure rules for conflict minerals and provisions on the safety of coal mines.

The EU, meanwhile, has taken a piecemeal approach. More than 50 post-crisis laws on the financial system have been proposed by Brussels. About two-thirds of these have been finalised. Broadly speaking, the EU laws cover the same ground as Dodd-Frank, but there are some significant differences between what the EU and US have adopted.

There is a view that the EU has been less decisive than the US in imposing tough rules on banks. Kenneth Haar, a researcher with watchdog Corporate Europe Observatory, says: “The EU rules have generally been adopted later than the corresponding US rules, and have generally been weaker. The result can be seen in the statistics. The biggest European banks are weaker than the Wall Street banks.”

In particular, US banks quickly repaid money that the US government sunk into them to keep them afloat during the crisis. The US government has even made a $40bn profit so far, according to the Bailout Tracker maintained by ProPublica, a non-profit investigative journalism group.

In Europe, by contrast, progress has been much slower. In the UK, for example, taxpayers still own about 80% of Royal Bank of Scotland, with no indication of when the value of its shares will rise enough to pay back its bailout. In the Netherlands, ABN Amro remains in government hands, while ING expects to finish repaying its bailout in mid-2015.

Different, but the same

Despite differences in approach, the banking regulations adopted in the EU and US have broadly similar aims. The objective is to make banks more robust in case of crisis, to improve supervision by regulators so that any risks coming down the tracks can be identified and dealt with earlier, and to have a framework in place so that any banks that fail go bust in an orderly way.

In the first area – bank robustness – both the US and EU are implementing an international standard known as Basel III. Under this, banks are required to hold at all times capital equivalent to 8% of their assets, adjusted for the riskiness of those assets, in order to have a cushion with which to absorb unexpected losses. The 8% level is the same as earlier international standards, but Basel III requires the composition of the 8% cushion to be of higher quality.

Robert Priester, deputy chief executive for regulatory policy at the European Banking Federation, says it is in this area that “Europe's banks had the most catching up to do. So far banks have been moaning and groaning, but it was necessary.”

The rules on capital cushions are accompanied by other new safeguards. One controversial issue in Europe is the “leverage ratio” under Basel III (see Box). Banks must also now have enough assets that can be easily sold to meet a 30-day liquidity crisis – a measure that Priester says should prevent runs on banks such as that at failed British bank Northern Rock in 2007.

However, setting money aside for possible liquidity crises means that “this money cannot be used for other purposes” such as lending to businesses that want to invest, Priester says.

Reserve capital could prevent bank failure

Intensive scrutiny

In supervisory terms, the consequence of the crisis for banks has been, unsurprisingly, much greater scrutiny. In the US, Dodd-Frank reformed the supervisory system and created new agencies, in particular the Financial Stability Oversight Council. This body is meant to oversee the financial system as a whole and to spot any emerging threats, in particular in the context of the globalisation of finance.

The European version of this has been greater transfer of powers to the European level, especially to the European Central Bank (ECB). Rym Ayadi, senior research fellow at thinktank the Centre for European Policy Studies, says the result will be “two-tier supervision – we will see some large banks supervised by the ECB while others will be under the local supervisors”.

In late October, the ECB is expected to publish the results of a “stress testing” exercise to measure the robustness of about 130 of Europe's largest banks. The stress-test results could include orders to banks to build up their capital cushions to protect against losses, or to do more to clean up bad debts still hanging over from the financial crisis.

For some banks, the test results could be painful. Their weaknesses could be publicly aired, with consequences for their share prices. But the stress tests will be a “milestone”, Ayadi says. “All this will help the banking industry to clean up.”

When things go wrong

The third main aspect of the bank regulation reform is crisis planning – what should be done if banks still get into trouble. During the financial crisis, some banks did go bust, most famously US investment bank Lehman Brothers. In Iceland, the big three bloated banks – Landsbanki, Glitnir and Kaupthing – all failed over the course of three days in October 2008. But in Europe in general, governments responded by stepping in to protect depositors, at great cost to taxpayers.

The implicit government guarantees also encouraged moral hazard in some of the banks at the heart of the crisis. This was most starkly illustrated by tapes leaked in Ireland of conversations between senior executives of Anglo Irish Bank, which was nationalised in 2009. The tapes revealed that the executives did not initially disclose the extent of the bank's problems to the Irish government for fear that the required bailout would be considered too big to be politically acceptable. By initially asking for a smaller amount of money, the executives guessed – correctly – that the government would then not be able to renege on its commitment to support the bank when the full details of the funding black hole were made public.

In the US, Dodd-Frank has ruled out future bank bailouts. Instead, the Federal Deposit Insurance Corporation will act as the receiver of failed banks, and will seek to protect depositors and pay off creditors. But ultimately, if the money is not there, everyone will take a loss. Dodd-Frank also requires large banks to have regularly updated contingency plans that set out a strategy in case of failure.

Compared with the US, the EU was also late to adopt rules in this area. In spring 2014, it finalised the Bank Recovery and Resolution Directive, a set of rules on winding down failed banks that are similar to those under Dodd-Frank. For a bank in trouble, Priester says, the directive gives powers of “escalating interference and insertion into the bank's management”, and this should mean that in most cases, struggling banks can be turned around before they fail.

The measures should “reassure the taxpayer that they are not in future the first line of defence”, Priester adds. “Banks should be able to go bust.”

Risky trading and salary caps

The reconstructed regulatory framework for banks has further facets. In the US, for example, Dodd-Frank introduced the Volcker rule, named after former US Federal Reserve chairman Paul Volcker. This is a general ban on proprietary trading by banks – in other words, high-risk trading in pursuit of high profits.

Such a ban is contentious in Europe, however, and the EU has not yet followed suit, though the walling off of trading from retail banking activities is under consideration. Robert Priester argues that proprietary trading is a relatively small part of the activities of European banks, and that to limit it could undermine the development of capital markets, which in Europe are smaller than in the US.

The EU has, however, capped bonuses paid to bank executives. In April 2013, the European Parliament approved a law that limits bonuses to 100% of salary, or 200% with shareholder approval. In the US, the rule under Dodd-Frank is more concerned with disclosure – that banks should publish details of the average pay of their staff, and the ratio of the CEO's pay to the average level.

A July 2014 report by consultants Mercer found that most EU banks were seeking shareholder approval for 200% of salary bonuses, or were increasing base salaries of executives to compensate for lower bonuses. And to get around the rules, 55% of EU banks were planning to pay cash “allowances” in addition to bonuses and salaries to top staff. This was “guaranteed cash with no variable link to performance, which is far from satisfactory”, according to Mercer head of talent Mark Quinn.

Priester says that in the past bonuses “were excessive” but caps cause problems. One concern is that banks lose out to hedge funds for the top talent. But banks can also suffer in other ways. Some, says Priester, are “struggling to get the type of employees they need for IT”, including experts in preventing fraud and cybercrime – they also potentially can lose out because of bonus caps.

Judgment reserved

The complexity of the post-crisis reform of bank regulation means that it will be some years before a judgment can be made about its success or not. Priester says: “In 10 years' time, we will certainly have learned the lessons from the crisis, and the reaction to the crisis.”

Not everyone is optimistic that the problems have really been fixed. “It remains to be seen if banks will come back to their old practices,” says Rym Ayadi: She points out that flatlining economic growth means that European banks will “logically have to take more risks” in order to generate the kind of profits they are used to. “From a fundamental point of view, I don't think the behaviour of banks will change,” she says. Avoiding another crisis will be a question of the effectiveness of supervision.

Tony Greenham, head of finance and business at thinktank the New Economics Foundation, is even more cynical. The post-crisis regulatory tsunami has failed to tame the banking beast, he says. Banking “is far more a machine for extracting wealth out of the rest of the economy than actually supporting wealth creation”. Another crisis is “inevitable” because “the structural defects of banking have not been fixed”.

Banks are still governed by “perverse incentives to create credit for speculative purposes, such as property investment or lending to hedge funds”, Greenham says. He adds: “Banking is a service with a strong imbalance of market power between buyer and seller, because most people find it very hard to understand financial products.” These factors combined mean that there will always be a risk of asset bubbles, like the subprime-driven housing bubble.

Ultimately, Greenham says, regulation can only go so far. “The most effective protection against exploitation is a culture where professional integrity and ethics always take first priority, profits come second. Banking regulation is not a substitute for this. The more that bankers’ activities are micro-managed and the less personal judgment is called on, the less personal responsibility they are likely to take.”

But it is far from clear if banks are ready, even in a more regulated environment, to accept greater ethical responsibility and lower profits.

Measuring bank health: the leverage ratio

One safety measure introduced by Basel III is the “leverage ratio” – a measure of the availability of cash to a bank on a day-to-day basis. This states that a bank's capital reserves should be at least 3% of its total assets. European banks are not keen on the idea.

Regulators in the US have gone further than Basel III on this, requiring a 4% leverage ratio. For the biggest banks it has been set at 5%, a rule that will come into force at the start of 2018. In the EU, meanwhile, no final decision on a leverage ratio has been taken. Instead, the European Commission, the EU's executive arm, is to study the idea and report in 2016, at which point a rule might be proposed. No mention in the EU has been made of going beyond the 3% Basel III stipulation.

The idea behind leverage ratios is that banks should publicly report the ratio, giving a measure of their relative health. For Corporate Europe Observatory's Kenneth Haar, the EU hesitation to introduce the leverage ratio is an example of the effectiveness of lobbying by banks. “They were afraid of the introduction of a leverage ratio. They've managed to avoid European rules that make any sense,” he says.

German banks dislike leverage ratios

Rym Ayadi, a senior research fellow at thinktank the Centre for European Policy Studies, says German banks in particular dislike the leverage ratio, because it does not distinguish between risky assets and the safe assets that German banks hold. The largest banks are “completely against leverage-ratio requirements”, she says.

Robert Priester, deputy chief executive for regulatory policy at the European Banking Federation, says that more discretion should be left to bank supervisory authorities to judge the extent to which a bank's leverage should be considered a risk. Banks “expect intensive scrutiny from supervisors,” and it would be better for supervisors to monitor banks and warn consumers if necessary, he says.

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