Will tightening regulation stop banks being banks?

It has become a cliché to say that the seeds of the next financial crisis are sown in the reforms arising from the current crisis. Unfortunately, it is true.

The complex panoply of regulation now being constructed is impossible for anyone to follow who does not have a PhD in either quantitative economics or nuclear physics. 

This means straight off that the regulators – who are usually less well paid and less experienced than top bankers – will not be able to grasp all the interlinkages and permutations when everything from Basel III, Dodd-Frank, MiFID II, the EU and the FSA is piled on top of each other. Risk will build in the system and they will be unable to either spot it or stop it.

The ultra-free-markets theorists argue that the more banking regulation, guarantees and consumer protection there is, the less safe banking becomes. Depositors and investors will assume the banks will be bailed out and so fail to conduct proper due diligence. Remove it all, allow banks to collapse when they get into trouble, and the financial system overall will work better.

Everything in moderation

We do not go as far as that. Good regulation (and a dose of good luck) in countries such as Canada and Turkey proved its worth during the last crisis. Some banks came through the troubles unscathed because of old-fashioned, risk-management common sense and by taking a conservative and sceptical approach to complex structures and frothy markets.

These are the qualities in banking the regulators should be seeking to nurture. Instead, they are trying to construct a regulatory edifice that will lay strict rules for every kind of banking activity and leave nothing to chance.

This is contrary to the fundamental purpose of banking, which is to mediate risk. If banks do not take risks they become ineffective, and in some spectacular ways the new regulations are threatening to stand in their way.

Let us take a concept such as mark-to-market, which is useful for making banks acknowledge losses instantly in their trading books. But used wrongly – to put a daily loss figure on the binary counterparty risk in a long-term derivatives contract  – and mark-to-market becomes nonsense.

Banks are being asked to hold capital against daily market movements that do not, in fact, impact their balance sheet.

Illiquid liquidity

Then there is the new penchant for banks holding sufficient liquidity and the specification of the precise assets that need to be held. Result: those assets become in short supply and in times of market panic they will become volatile and illiquid.

Regulators have noted that the common adoption of Basel II by banks globally made them all play the cycle in the same way – with negative outcomes. That is why Basel III demands they hold an additional  2.5% countercyclical buffer of capital.

Meanwhile, many of the other new rules are forcing banks to such adopt mechanistic behaviour that the next blow up will be even more sequenced and pronounced than the last one.

Sadly we do not seem to have learnt very much.