We Need to Talk About Bank Supervision

Howard Davies September 27, 2023 00:49

Bank capital is back in the financial headlines. In late July, US banking regulators, led by the Federal Reserve, announced plans to finalize the so-called Basel 3 reforms (which banks like to call Basel 4, owing to their significant impact). The aim, according to a joint agency proposal, is “to improve the strength and resilience of the banking system” by modifying large capital requirements to better reflect underlying risks, and by applying more transparent and consistent requirements.

The announced proposals are tougher than many expected. They will cover more banks – including some that had benefited from Trump-era concessions – and they will require banks to include unrealized losses from securities in their capital ratios (among other changes). Overall, US regulators expect the most complex banks to increase their capital by 16%.

US banking supervisors, led by Fed Vice Chair Michael S. Barr, clearly have been emboldened by the spate of bank failures that started with the collapse of Silicon Valley Bank this past spring. But though the political mood has changed after that embarrassing episode, there is still fierce opposition to the new regulations. Last week, David Solomon, the CEO of Goldman Sachs, warned that the “new capital rules have gone too far … they will hurt economic growth without materially enhancing safety and soundness.” Likewise, JPMorgan Chase CEO Jamie Dimon believes they will increase the cost of credit, potentially making banks uninvestable.

One can find even more blood-curdling forecasts on the Bank Policy Institute’s “Stop Basel Endgame” website, which warns of “real consequences for families and small businesses across the country.” Clearly, the proposed rule changes have become a political battle. Nor is this solely an American issue. The Bank of England has also issued rather tough proposals – though British banks have eschewed high-flown rhetoric in responding. (When American bankers say, “These proposals will end human life as we know it,” English bankers merely admit to being a little concerned.)

The debate will play out differently in different places over the next few months. In a recent working paper, Good Supervision: Lessons from the Field, the International Monetary Fund points out that capital ratios are currently higher in European banks than in American ones. That may partially explain why the European Union’s Basel 3 implementation plans do not envisage increases on the scale proposed in the United States.

But more to the point, the IMF authors conclude that the recent bank failures do not have their roots in capital weakness. As the Swiss National Bank noted during the collapse of Credit Suisse, “meeting capital requirements is necessary but not sufficient to ensure market confidence.” The salient problem was that investors lacked confidence in the bank’s business model, and that depositors were withdrawing funds at a rapid rate. A lack of liquidity, rather than a capital shortage, was the straw that broke that camel’s back.

Similarly, US authorities’ reports on this year’s bank failures concluded that risky business strategies, compounded by weak liquidity and inadequate risk management, lay at the heart of the problem. But though supervisors had identified many of these problems, they “didn’t insist or require the banks to respond more prudently while there was time to do so,” the IMF authors explain.

Taking banking supervisors’ recent reviews as their starting point, the IMF authors draw broader lessons from the post-financial-crisis reforms and their differential implementation across jurisdictions. Notably, an absolute shortage of capital does not feature prominently among the weaknesses they identify, though they do argue that some countries use the Basel minimum requirements as a “one size fits all” rule, thus failing to account for differential risks. There has been little use of the “Pillar 2” process, whereby regulators can require additional capital if they determine that risk management is weak.

The IMF authors see far bigger problems in the lack of skilled staff in many places, and in the pressure regulators feel to make politically expedient, rather than prudent, decisions. For example, some supervisors pay little attention to corporate governance and business models, partly because they lack the tools and authority to do so. But supervisors also have failed to help themselves by under-allocating resources for oversight of small firms, and by following poor internal decision-making processes.

The IMF’s overall conclusion is that regulation, in the sense of capital or liquidity rules, “is rarely, if ever, enough.” Far more pertinent is the quality of supervision, and of the supervisors themselves.
It is an important message, and one that central banks and bank regulators around the world should take to heart as the debate over capital requirements heats up again. Experience shows that marginal increases in capital ratios, or a touch of inflation in risk-weighted-asset calculations, may have far less impact than low-cost programs to upgrade supervision. We need a cultural shift to embolden supervisors to act on their concerns. Earlier interventions, using tools and powers supervisors already have, could have helped avert some of this year’s unfortunate bank failures.

Copyright: Project Syndicate, 2023.

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Howard Davies

Chairman of the Royal Bank of Scotland