In the wake of the financial crisis of 2008–09, the banking regulatory framework was overhauled both at the global and local level. At the global level, the Basel Committee on Banking Supervision (BCBS) developed new principles for liquidity management and increased capital requirements. At the local level, regulators in a number of jurisdictions significantly changed their calculations of the necessary levels of liquidity and capital: in the US, for example, the Federal Reserve put in place the Comprehensive Capital Analysis and Review (CCAR) mechanism, an annual stress-testing and capital planning exercise; in the EU, the European Central Bank (ECB) put in place the Supervisory Review and Evaluation Process (SREP), a bi-annual process to assess banks’ risk profiles and make supervisory decisions on capital and liquidity, supported by insights from the European Banking Authority’s bi-annual stress test; and in the UK, the Prudential Regulation Authority (PRA) set out a new approach based around stress-testing to inform capital requirements. These and other measures have resulted in banks building up substantial capital and liquidity buffers in the past few years.
The initial financial market shock from COVID-19, from mid-March to mid-April 2020, provided the first major test of these changes. On the whole, the banks came through this period of volatility relatively well, albeit supported by central bank intervention and fiscal programmes of unprecedented scale. Additional market turbulence occurred in October 2020 and January 2021 during the subsequent second and third waves of infections, but this volatility was less pronounced than during the first wave. The arrival of apparently effective vaccines in late November and December 2020, following successful trials, has reduced uncertainty about the duration of the pandemic, at least in parts of the developed world. That said, the macroeconomic effects of the pandemic, and its impact on bank balance sheets, will continue to feed through into financial markets and banking systems, which could lead to further turbulence.
Although the overall effect on banks and economies is unknown, it is not too early to investigate and draw some lessons from the experience of the past year. The recently announced review by the Financial Stability Board (FSB) for the G20 of the lessons to be learned from the crisis is therefore to be strongly welcomed. Market reactions during the first wave of infections were long and deep enough to pose credible tests of the robustness of established risk management frameworks. Threats to credit, still the biggest source of risk exposure in banks, have been staved off thanks to massive public sector support for economies. Meanwhile, the effects on individual banks of the short- and medium-term volatility in financial markets can be seen in their public filings: banks with significant capital market activities have done quite well, as volatility can be good for (some) business, e.g. trading.
But positive developments on the vaccine front – really the only true exit strategy – continue to be tempered by bad news on the virus front, as more contagious and possibly more virulent mutations are emerging in many parts of the world. An unexpected prolongation of the economic crisis could occur if current vaccines fail against emerging variants, if the unwinding of government support for lending is premature or poorly coordinated, or if a completely new and unforeseen event causes a shock to economies.
This briefing paper addresses four broad questions in the context of the above issues:
- It reviews the performance of the BCBS regulatory framework in the period up to the pandemic.
- The analysis also considers which aspects of the framework worked well during the initial phase of the COVID-19-related economic shock and identifies where unintended consequences occurred.
- It sets out a number of the issues that need to be examined in the FSB’s review of the regulatory framework’s performance in the crisis.
- It explains the benefits that a thorough review could deliver at this stage.
