Global financial stability was high on the agenda when the G-20 met Nov. 15-16 in Brisbane. One notable result was the endorsement of the Financial Stability Board's plan to end "too big to fail," the details of which board Chairman Mark Carney released Nov. 10. Considered a major contributor to the 2008 financial crisis, too big to fail has been under regulatory attack for several years. Meanwhile, banks (particularly in Europe) have been groaning under the weight of regulation that inhibits their ability to lend, and so growth continues to flatline. While defeating too big to fail is an important task, it could bring the eurozone down with it.
The drive to regulate the banks after the crisis of 2008 follows the usual pattern of financial crises: Immediately after the crisis, stringent regulations are introduced to ensure that it cannot repeat itself; over time, the memory fades and complacency grows; regulations are gradually stripped away until a new bust; and the process starts over. The cycle was last seen after the 1929 Wall Street Crash, after which the Glass-Steagall Act of 1933 ensured that U.S. banks could not take such risks again. But a misplaced confidence in banking risk processes grew, and the 1970s and 1980s saw an extended period of deregulation on both sides of the Atlantic.
The crisis of 2009 was to a large extent a result of banks' ability to take gigantic risks alongside an interlending culture that resulted in a connected network of loans, meaning that if one bank was allowed to fail, the whole system might follow. Ever since Harry Thornton's An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in 1802, central bankers have known that allowing insolvent banks to fail is a key principle in ensuring that the others do not take extreme risks, but Thornton also wrote that a lender of last resort's first responsibility was to the system as a whole; too big to fail linked the two, creating the bind faced by central bankers in 2008-09. Regulations thus far have been focused on limiting the risks a bank can take, while Carney's latest measures are designed more to limit the interconnectedness of the market, creating a situation where insolvent global banks could be allowed to fail safely.
The process of regulating the banks began very soon after the crisis. Frustrated with the system that had forced them to reward banks' irresponsible actions with government funds, national leaders agreed to regulatory measures at G-20 summits in 2009 and 2010. The Financial Stability Board was set up in 2009 to watch for weaknesses in the global system, while in 2010 the highly stringent Basel III standards were endorsed at the G-20 summit in Seoul. Basel III was designed to make banks less risky by requiring that they hold more assets to back up their loans while also introducing new supervisory requirements.
Carney's new measures, called total loss-absorbing capacity (TLAC), are geared more toward ensuring that a diverse range of investors and institutions hold the bonds and shares of each bank and that they can absorb the shock of its collapse. This situation allows for a so-called bail-in, where investors pay the price instead of depositors or taxpayers. As a result, banks could be forced to hold as much as a quarter of their assets (weighted for risk) in bonds and shares — on top of Basel III requirements.
Side Effects for Europe
But the solution is not so easy. The changes are having harmful side effects, specifically in the place least equipped to handle them: the eurozone. In a seemingly unfortunate coincidence, Europe — the world's economy that is currently most in need of a break — is particularly vulnerable to this wave of regulation and simultaneously has been most targeted by it. Recent meetings of world leaders have generally involved hand-wringing about Europe's stagnant economy, which is considered the greatest danger to global growth in the short term.
The first reason for its vulnerability to regulation is that Europe's market, 99 percent of which is made up of small businesses, overwhelmingly receives its funding through bank loans. Markets like the United States and the United Kingdom, on the other hand, have more efficient bond markets. Almost all of European Central Bank President Mario Draghi's unorthodox policies this year have been attempts to get Europe's banks lending again, ideally to small- and medium-sized enterprises. Negative interest rates make it painful for banks to hold funds on their balance sheet, encouraging them to lend, and the program known as targeted longer-term refinancing operations provided banks with cheap loans on the condition that they were lent into the marketplace. This month's asset-backed securities and covered bond-buying program has the dual purpose of freeing up bank funds that could be used for new loans and stimulating the asset-backed security market, a development that could make Europe begin to look more like its Anglo-Saxon counterparts. The next step — buying corporate bonds — would provide funding directly to large companies, which could then lend it to smaller companies.
The second reason for Europe's vulnerability is that financial reform is best undertaken during a period of loose monetary policy. Although interest rates are negative, Germany's aversion to outright quantitative easing is compounding the problems for Europe's banks relative to their Anglo-Saxon counterparts.
The targeting of Europe in the latest reforms is again linked to market structure. The TLACs have been developed to cover the world's 30 systemic banks, of which the eurozone is home to 11. The three emerging markets representatives, all Chinese, have been exempted for the time being because of "different market conditions." The explanation is that Chinese financial markets are not developed enough to support the kind of bond-raising required, though China probably would have also rejected any attempts to control its banks at this stage since it uses them directly to manage its slowing economy. The reforms require an increase in debt, something that will be more easily undertaken in the United Kingdom and the United States, where a holding company structure is common; Europe's banks have been advised to transform themselves into this structure, a time-consuming and costly process.
The upshot is that Europe's banks are set to suffer an uncomfortable period of readjustment after already experiencing a period of deleveraging since the crisis. The process of issuing bonds and shares will impair profitability still further, while one way of limiting the amount of money to be raised would be to reduce the assets on the balance sheet, i.e., loans. A move in that direction works directly contrary to the European Central Bank's initiatives to stimulate lending. The one strange consolation is that Draghi's attempts have been failing anyway, since it has become clear that Europe's lending problems sit not on the supply side so much as the demand side — in other words, a lack of desire to borrow. Thus an impairment in supply may not have a huge immediate effect on the picture, though it will surely prove hugely unhelpful when Europe does reach the stage in its recovery when it wants to start borrowing again and it finds that its banks are drowning in capital-raising and balance sheet-shrinking activities.
Continuing the Cycle
But where does the authority for all of these regulations come from, and how will they be enforced? The answer is that the Financial Stability Board has no enforcement power at all. The regulations have been developed in conjunction with G-20 countries' representatives, who meet twice a year. The new regulations are "soft law," which is to say that peer pressure, and a recognition that they reflect best practice, will lead national and regional regulators to undertake the measures. This theory has worked so far — with the global climate leaning toward de-risking banking, all players have largely been on the same page. Had Carney's measures required emerging market banks to raise TLACs, there might have been more conflict, since Chinese banks were not culpable in 2008 in the same ways as their Western counterparts.
As for the banks themselves, they appear to have become largely resigned to their fate. The one grumble that has arisen thus far in Europe has been from banks large enough to be considered systemic, such as UniCredit, that have a slightly smaller competitor in their market, such as Banca Intesa, which has escaped the TLAC requirements. But rather than resistance against TLACs, the call has been for a TLAC equivalent to be introduced for smaller banks as well so that they do not enjoy a competitive advantage over the larger banks.
The increase in banking regulation follows a predictable path. In the West, it will succeed in its ambitions of ending too big to fail, at least in the medium term. Ultimately, complacency and greed will erode the new regulations and a banking crisis will result, though that will fall within the purview of a regulator far in the future. In the emerging world the future is less clear, since there is less anti-banking sentiment in these countries, there is also less political capital to be gained by bashing banks. If in the future the Financial Stability Board introduces a regulation that is considered harsh by emerging market players, it is quite possible that a split will occur, meaning that these developing banks will be free to explore their own separate route. Under such circumstances, a 2008-style banking disaster in one or more emerging markets could easily be the result. In the short term, the new regulations can only limit Europe's attempts to return to growth by stifling its banking system, and a Europe that is not growing is in grave danger of breaking up.
