We Need to Talk about Banks and Their Supervision

Bank capitalization is in the news again. At the end of July, U.S. banking regulators, led by the Federal Reserve (the Fed, the federal system of U.S. central banks), announced plans to complete the so-called Basel 3 reforms (which banks like to call Basel 4 because of their significant impact). According to a joint proposal, the aim is to "improve the strength and resilience of the banking system" by adjusting major capital requirements to reflect underlying risks better and applying more transparent and consistent requirements.

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

U.S. banking regulators, led by Fed Vice Chairman Michael S. Barr, are driven by the wave of bank failures that began with the collapse of Silicon Valley Bank last Spring. However, while the political mood has changed after that painful episode, there is still fierce opposition to the new regulations. Last month, David Solomon, the CEO of Goldman Sachs, warned that the "new capital rules have gone too far... they will harm economic growth without materially improving safety and soundness." Jamie Dimon, the CEO of JPMorgan Chase, also thinks that they will increase the cost of credit, which may make banks unable to invest/ lend.

Even more blood-curdling predictions can be found on the Bank Policy Institute's 'Stop Basel Endgame' website, which warns of 'real consequences for families and small businesses across the country.' The proposed rule changes have become a political battle. This is not just an American issue either. The Bank of England has also made some rather tough proposals – although the British banks have refrained from high-sounding rhetoric in their response. (When American bankers say, "These proposals will end human life as we know it," English bankers merely admit to being slightly concerned).

The debate will proceed differently in different places in the coming months. In a recent working paper, 'Good Supervision: Lessons from the Field', the International Monetary Fund points out that capital ratios at European banks are currently higher than at U.S. banks. That may explain why the European Union's Basel 3 implementation plans do not provide for increases on the scale proposed in the United States.

However, more importantly, the IMF authors conclude that recent bank failures are not due to a lack of capital. As the Swiss National Bank noted during the collapse of Credit Suisse: "Meeting capital requirements is necessary but not sufficient to guarantee market confidence." The main problem was that investors needed more confidence in the bank's business model and that depositors were withdrawing their money at a rapid pace. A lack of liquidity, rather than a capital shortage, was the straw that broke the camel's back.

Similarly, in their reports on this year's bank failures, U.S. authorities concluded that risky business strategies, compounded by weak liquidity and inadequate risk management, were at the heart of the problem. Nevertheless, while regulators had identified many of these problems, "they did not urge or force banks to act more cautiously while there was still time to do so," the IMF authors explain.

The IMF authors take the recent assessments by banking supervisors as a starting point and draw broader lessons from the post-financial crisis reforms and their different implementations across jurisdictions. Notably, an absolute shortage of capital does not figure prominently among the weaknesses they identify. However, they state that some countries use the Basel minimum requirements as a 'one size fits all' rule, thus failing to consider other risks. There needs to be more use of the 'Pillar 2' process, under which regulators can demand additional capital if they determine that risk management is weak.

The IMF authors see much bigger problems in the need for more skilled staff in many places and in regulators' pressure for political expediency rather than sensible decisions. For example, some regulators pay little attention to corporate governance and business models, partly because they need more resources and authority. Nevertheless, regulators have shortchanged themselves by allocating too few resources to oversee small businesses and following poor internal decision-making processes.

The IMF's general conclusion is that regulation, in the sense of capital or liquidity rules, is 'rarely or never enough.' Much more relevant is the quality of supervision and the supervisors themselves.

It is an essential message that central banks and banking regulators worldwide should heed as the capital requirements debate reignites. Experience shows that marginal increases in capital ratios, or a bit of inflation in risk-weighted asset calculations, have much less impact than cheap programs to improve supervision. We need a culture change to encourage regulators to act on their concerns. Earlier intervention, using tools and powers that regulators already have, could have helped prevent some of this year's unfortunate bank failures.