Bank Regulations after the Global Financial Crisis: Good Intentions and Unintended Evil

• Author: Jean Dermine
• Published date: 01 September 2013
• Date: 01 September 2013
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12017.x

Bank Regulations after the Global

Financial Crisis: Good Intentions and

Unintended Evil

Jean Dermine

INSEAD, Boulevard de Constance, F‐77300 Fontainebleau, France

E-mail: jean.dermine@insead.edu

Abstract

In this essay, we analyse the impact of the capital and liquidity regulations and call

attention to the fact that the banks’responses might create unintended evil: a

reduced supply of bank loans, incentives to securitise assets, and adverse incentives

on bank risk monitoring. The conclusion is that privately‐based mechanisms that

put most creditors at risk are the best way to increase the soundness of banking

markets. It is argued that interbank debt should be put at risk because banks have a

comparative advantage in risk monitoring. As putting short‐term interbank at risk

increases the danger of sudden deposit withdrawals, a mechanism is needed to

extend the maturity of short‐term debt at the time of a credit‐led panic.

Keywords: bank regulations, resolution, financial crisis

JEL classification: G18, G21

The severity of the global crisis with large public costs incurred in bailing out banks has

prompted a chorus of ‘Never Again’. Bank corporate governance, regulation and

supervision had failed in several countries, a view reinforced by the fact that banking

crises seem to be a recurrent phenomenon. This succession of financial crises has inspired

the call for a review of bank regulation and supervision around the world. The new

regulations concern primarily bank capital, liquidity, compensation and corporate

structure. In this article, we provide a critical assessment of the regulations on capital and

liquidity, taking into account the imperative need to preserve the economic functions

performed by banks.

The paper is structured as follows. In the first section, we evaluate the Basel III

regulation on capital and argue that one needs to take into account both static and dynamic

impacts. A critical analysis of the role of ‘bail‐in’securities such as contingent convertible

bonds (co‐cos) in bank capital is provided. In the second section, we evaluate the Basel III

regulations on liquidity, the ‘liquidity coverage’ratio and the ‘net stable funding’ratio.

The author is grateful to an anonymous referee, J. Doukas, D. Gromb, J. Gual, P. Hartmann

and R. Noyes for insightful comments.

European Financial Management, Vol. 19, No. 4, 2013, 658–674

doi: 10.1111/j.1468-036X.2013.12017.x

© 2013 John Wiley & Sons Ltd

Finally, we argue that privately‐based mechanisms are required to enhance the

development of sound banking markets. Not only ‘bail in’bonds but also interbank debt

should be put at risk because banks have a comparative advantage in risk monitoring. As

putting short‐term interbank at risk increases the danger of a bank run, a mechanism is

needed to extend the maturity of short‐term debt at the time of a credit‐led panic.

1. Basel III Capital Regulation

Following the default of the German Bank Herstatt in 1974, the Basel Committee of

Banking Supervision developed a minimum capital regulation standard for international

banks: from the 8% Cooke ratio of Basel I agreed to in 1988, to the Market Risk

Amendment of 1996, Basel II in 2004, Basel 2.5 in 2009, and Basel III in 2010. The

periodic revision and refinement of the Basel capital regulation reflects the great difficulty

in defining a capital adequacy ratio. One indication that equity is perceived as very

expensive by banks is the continuous lobbying to reduce the equity component. The Basel

I and II accord capital included a Tier 1‐Tier 2 system with a minimum Tier 1 of 4% which

included equity and a Tier 2 with subordinated debt (minimum maturity of 5 years) among

other instruments. A distinction existed between going‐concern capital (equity absorbs

losses while the bank is solvent) and gone‐concern capital (subordinated debt holders bear

losses only when the bank is put into formal bankruptcy proceedings). An additional sign

that debt was perceived as cheaper than equity was the lobbying for inclusion into bank

capital of hybrid Tier 1 securities. These are coupon‐paying bonds with restrictions on

payments when a bank report losses. Finally, when a capital standard was introduced in

1996 to cover market risk, bank capital was allowed to include a Tier 3 component,

consisting of subordinated debt with a shorter minimum maturity of two years. Two

complementary explanations are given for this preference for debt finance: A higher cost

of equity caused by several economic reasons to be discussed later or the attempt by banks

to exploit a distortion in the system, the nearly‐free guarantee given by States to debt

holders of too‐big‐to‐fail banks.

In our assessment of the Basel III capital regulation, we call attention to the need to

distinguish a static analysis from a dynamic one that takes into account the banks’

responses to the regulation.

Consider a bank with assets (loans) funded with retail or corporate customers’deposits,

interbank debt, bonds, and equity. In case the bank’s assets fall in value, the question

arises as to which parties will shoulder the loss. The perspective is static concerning the

distribution of losses among several parties.

Customers’deposits and interbank debt are often fully insured. Depositors are

protected to prevent bank runs

1

or because they are considered ‘uninformed’. Interbank

deposits are protected for two reasons: first, due to the complex and opaque nature of

transactions, often with close‐out netting agreements, a panic and a bank run on solvent

banks could start if there is a slight risk that interbank depositors could face a loss; second,

the insolvency of a bank could create a domino effect leading to systemic risk.

When the objective of regulators is to avoid bank runs, bank closures with negative

spillovers on the economy and/or to reduce the likelihood of costly government

interventions, the response seems obvious: more severe regulation on bank capital and, in

1

The run on the British Northern Rock in 2007 started when depositors realised that only 90%

of the deposit balance was insured (Hamalainen et al., 2012).

© 2013 John Wiley & Sons Ltd

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