Photo: DAVID ILIFF. License: CC-BY-SA 3.0

Post-Financial Crisis Regulation Through a Critical Lens

By: Ellam Wawire Kulati, CASE Analyst and Christopher A. Hartwell, President of CASE Management Board

The 2007–2008 financial crisis appeared to expose a need for revised financial regulation in several areas, including capital and liquidity, derivatives, and consumer protection. This perception led to large numbers of rules and regulations formulated and enacted post-haste across the globe, reforms meant to be key in restoring the trust and confidence of the general public in the banking sector. Additionally, post-crisis financial regulation reform was largely meant to lead to international harmonization and coordination of financial regulations. However, as Stefan Ingves, Chairman of the Basel Committee on Banking Supervision recently noted, “it is a good time to take a step back and ask how the different bits and pieces of the regulatory framework fit together.”

According to former Commissioner of the U.S. Securities and Exchange Commission Daniel M. Gallagher, harmonization of financial regulation appears to be the imposition of a one-size-fits-all regulatory standards on sovereign states. Pre-crisis U.S. and EU financial institutions had disparate regulations, he adds, but, in efforts to reduce friction between them, transatlantic efforts were made to find common ground with respect for national sovereignty. The aim of these efforts was for regulators to realize that despite having the same regulatory goals, different approaches were of different qualities. Part of the post-crisis regulations such as the Dodd-Frank Act have derailed this participative harmonization.

The “Dodd-Frank Wall Street Reform and Consumer Protection Act” was adopted in America in an attempt to address systemic risk and long-term sustainability in the US financial system after the crisis. Years after adoption, the act has been accused of spending scarce resources to implement provisions which did nothing to avert the crisis, while failing to fully carry out directives of the act that were responsive to the crisis. For example, improvement of the management of systemic risk is among the many aims of the Act. Before the crisis, financial institutions were regulated according to formal labels — banks, investment banks, insurance companies, et al. — and not to their actual actions. As such, large institutions could choose regulators that would offer the least restrictive supervision (it should be noted that institutions had a large number to choose from, as the financial sector in the US was already the most heavily-regulated sector of the economy). This “regulator roulette” resulted in ineffective supervision. The Fed, authorized by the Dodd-Frank Act, could now, in addition to regulating banks, supervise and regulate all financial firms whose failure could be hazardous to financial stability, regardless of form. Consequently, banks and non-bank financial institutions with substantial systemic influence now had to meet stricter capital and liquidity requirements, in order to withstand adverse economic conditions.

While an effect of these higher capital and liquidity requirements (reduced bank risk-taking incentives and providing a buffer against losses) may support growth, others (indirect bank lending) have been found to negatively impact the economy. Researchers at the Kennedy School of Government at Harvard University also discovered that the Dodd-Frank regulations are most onerous to the smaller entities, who rarely have teams of lawyers able to comply with the myriad of requirements. This same research found that the decline of community banks, for instance, can be attributed to the legislation.

Basel III, the third agreement by the Basel Committee on international banking supervision, also attempted to address the financial crisis. It aimed at improving financial shock absorption using liquidity coverage ratios, net stable funding ratios, establishment of liquidity risk management supervision principles, and monitoring metrics. Although it was a proponent of higher capital requirements akin to those of the Dodd-Frank Act, it also introduced countercyclical measures, where banks had to set aside more capital during credit expansion and vice versa. This regulation was also not without critics. Some research has shown that the regulation will result in increased borrowing costs for banks. Cosimano and Hakura, in their 2011 paper “Bank Behaviour in Response to Basel III,” find that a 1.3% increase in required equity-to-debt ratio will increase loan rates by 0.16% across the 100 largest banks in the world. It will also reduce loans from 4.6% in countries that experienced the crisis to 14.8% in those that did not experience it directly. Likewise, previous increases in equity requirements, such as those of Basel II regulations, led to the creation of shadow banking.

Worldwide changes in financial regulation, post-crisis, are meant to have reduced risk not only through increased capital requirement, but also through reduced leverage ratios and regular stress testing. Theory suggests that this should result in a decline in the measures of risk in the financial market. To this end, Natasha Sarin and Lawrence Summers of Harvard sought answers to the question, “Have big banks gotten safer?” They find that financial information provides little support for the view that these institutions are significantly safer than they were before the crisis, with some of the information pointing to increased risk. This is based on information on stock price volatility, options based estimates of future volatility, credit swaps, earning-price ratios, and preferred stock yields in major and midsized institutions in America together with major institutions in the world. Sarin and Summer’s research does not support further regulation, citing the declines in franchise value due to the regulatory activity and the prospect of future regulation. Indeed, they show that further regulation, forcing a one-size-fits-all approach, could actually increase systemic risk.

In sum, the early results on the flurry of financial regulations enacted during and after the global financial crisis are not promising. Combined with the easy money of the past decade which has made another crisis more likely, policymakers should look at the drivers of financial crises more holistically. Unfortunately, we are not optimistic that this result will obtain.

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