The shape of today’s banking regulatory framework largely reflects the responses to the 2008–09 global financial crisis, in which bank fragility played a major role. With hindsight, banks at that time were inadequately capitalized, held insufficient liquidity reserves, and had deficient risk management and control programmes in place. Moreover, banks did not help themselves by exhibiting rather ill-judged behaviour. This included: lending to borrowers who could not reasonably repay their loans (e.g. through mortgages at over 100 per cent loan-to-value ratios to borrowers on low incomes); creating and selling structured securities whose risks were not really understood; and taking for granted easy access to wholesale funding markets. During the crisis, multiple banks became insolvent, and Western Europe and the US were pushed into the worst recession since the Second World War, despite massive public sector intervention.
The updated international regulatory framework that was subsequently put in place both widened the scope of the risks against which banks had to hold financial resources and required banks to introduce systems more sensitive to such risks. The result was that bank capital and liquidity reserves substantially increased in the years after the global crisis. For example, the core equity of the largest European banks went from an average of 9.1 per cent of risk-weighted assets (RWA) at the end of 2008 to 16.5 per cent at the end of the third quarter of 2020, while the core equity of ‘global systemically important banks’ (G-SIBs) in North America rose from 12.5 per cent of RWA to 14.3 per cent over the same period.
The series of reforms responsible for this was nicknamed ‘Basel 3’ (with subsequent reforms commonly referred to as Basel 3.5 and Basel 4). Basel 3 was the result of international collaboration, and the speed of its drafting was made possible by the pre-existing multilateral structure of the BCBS. This is important, since it demonstrates what can be accomplished via a well-functioning multilateral organization.
Changes to local regulatory frameworks since 2008 have often been uncoordinated, with differences emerging between jurisdictions both in the detail of the reforms enacted and the timing of their implementation.
In contrast, the changes to local regulatory frameworks since 2008 have often been uncoordinated, with differences emerging between jurisdictions both in the detail of the reforms enacted and the timing of their implementation. Some regulators have added their own bank capital and liquidity requirements, such as the so-called ‘Swiss finish’, the CCAR stress-testing programme in the US, and bi-annual stress tests in the EU. Some of this tailoring within regulatory jurisdictions has been necessary to reflect variations in the development and sophistication of national financial systems, though it is also motivated by differences in risk appetite on the part of the relevant authorities.
Unfortunately, this has led to what can be described as a ‘Balkanization’ of bank capital and liquidity rules, creating a patchwork of local-level regulation and implementation at odds with the more uniform overall design. From a local regulator’s perspective, a tailored approach seems understandable. Given that one of the features of the 2008–09 financial crisis was that global banks failed in local jurisdictions (Lehman Brothers, for instance, failed first through its UK subsidiary), with domestic taxpayers footing the bill, each local regulator was motivated to ensure that banks (including local subsidiaries of global banks) would have enough capital and liquidity in that jurisdiction.
But this fragmentation of rule-making, combined with the lack of an international bank solvency regime (which means that no set of rules governs the order of precedence of creditors if an international bank goes bankrupt), has made cross-border banking more expensive. It has resulted in capital and liquidity being trapped in foreign bank subsidiaries and has led to higher capital charges against some foreign government assets than the charges local banks would face against holding the same assets.
