Things have changed significantly for the banking sector over the past two decades. Today’s regulation is far more intrusive and complex, while its architecture favors arbitrage and incentivizes shadow banking.
A recent invitation to deliver a lecture at a financial institution celebrating its 20th anniversary gave me the opportunity to reflect on the changes we have experienced over the past 20 years. Two decades ago, I was a young commissioner at the National Securities Market Commission, and a few years later I chaired various international groups such as the now-defunct Banking Advisory Committee and Committee of European Bank Supervisors, and the still-functioning Financial Action Task Force and Joint Forum. And twenty years later, I have ended up chairing the Spanish Banking Association.
A Different Landscape
Twenty years ago, the Basel Committee was beginning to debate Basel II. In those days, regulators were fascinated by the science of finance, its pricing models, and the ability of large banks to manage risks. Consequently, they were willing to allow large banking institutions to use internal models to calculate the probability of default, exposure, and loss given default for regulatory capital purposes (in the jargon, PD, EAD, and LGD). In short, we regulators had blind faith in the technical competence of large banks.
For their part, large institutions were ambitious enough to want even more flexibility than that granted by Basel II. They aspired for a future Basel III agreement to allow them to use the diversification that existed among different portfolios for calculating capital adequacy across the entire balance sheet (what we call “full portfolio models”).
Twenty years later, we have Basel III, but of an entirely different nature. This Basel III, which is by far much more intrusive than previous regulations, reflects a total loss of faith on the part of supervisors regarding the capabilities of the financial industry. In fact, it is even worse because they have also lost faith in the proper conduct of banks and in their ability to work according to simple principles, such as avoiding conflicts of interest or respecting fiduciary duty toward clients. Without doubt, this has represented a devastating loss for the banking industry.
Furthermore, it explains why we not only have higher capital requirements (in volume and quality), but also higher liquidity requirements; resolution rules that include overwhelming minimum requirements for own funds and eligible liabilities or MREL; stress tests; or processes such as internal capital and liquidity adequacy assessments, as well as governance rules, among many others.
Things are no better in the conduct area. In this field we have the second iteration with MiFID II and PRIIPs (regulations on packaged retail investment and insurance products), immensely complex and intrusive regulations that offer no relief whatsoever to the industry.
Drowning in Data
There are two particularly concerning aspects of the regulation issued during these 20 years. First, the complexity of the new rules is immense. The consolidated text of Basel III, published a few months ago by the Basel Committee, is 1,868 pages long; MiFID II reaches 5,000 pages of text; the updated rules on capital requirements and resolution, as well as the guidelines published by the European Banking Authority and the respective national authorities, add another 1,300 pages or more to the body of regulation.
As Mark Carney recently said, “the Bank of England receives 65 billion data points annually from supervised institutions. Just putting them in context and reviewing them would be equivalent to each supervisor reading the complete works of Shakespeare twice a week, every week of the year.”
Cause for Concern
Why does this complexity concern us so much? Because it is almost “mission impossible” to understand how the interactions of all these rules work with each other. It is a black box for both regulators and regulated firms.
The second aspect of our concern relates to the architecture of regulation: we regulate by type of financial institution and not by type of activity. And the problem with this kind of regulation is that it clearly favors arbitrage, something we already saw in 2007. AIG, the monolines, structured investment vehicles (SIVs), Lehman Brothers, and Bear Stearns were not banks and were not subject to banking regulation: they were insurance companies, securities firms, and special purpose vehicles (SPVs). Now, in this world of technological revolution that is blurring the boundaries between financial and technology companies, the new regulatory model will be even more prone to capital arbitrage and the emergence of risks within the unregulated shadow banking sector, including fintechs and large bigtechs.
But we cannot deceive ourselves. Our main challenge concerns conduct and ethics. If we want to survive the present century, we need to restore the reputation of banks before regulators, politicians, the judiciary, and society as a whole. Otherwise, we can expect that over the next 20 years future regulations will be even stricter, more inflexible, complex, and unbearable.
José María Roldán, Chairman of the Spanish Banking Association
