Economic trends

The search for a safer banking system must go on

The global economic outlook needs to improve and this requires learning the right lessons from the recent past

The past, present and future converged seamlessly last week at Eurofi in Vilnius, where policy makers, regulators and bankers discussed lessons from the 2008 financial crisis.

Five years after the collapse of Lehman Brothers, which triggered a near-collapse of the financial system and set in motion a severe economic downturn, there’s a mixed prognosis for the health of the banking system.

Major banks are holding more capital, particularly in the US. And in Europe, where banks raised an additional EUR20 billion in capital in 2013, there are welcome signs of a pick-up in economic activity. Nevertheless, the economic recovery in Europe is weak and there’s a general sense that the financial system has not fully recovered.

The philosophical divide at Vilnius was between regulators, who argued that the only way to stabilise the financial sector was to raise bank capital levels (and reduce return on equity), and banks who feel that they are being asked to hold too much of capital in too many jurisdictions.

Regulators should not over-burden institutions by introducing new requirements

To the refrain from regulators that banks should stop ‘complaining’ about higher capital requirements, the banks appealed for greater regulatory coordination which would help reduce claims on finite bank capital from competing jurisdictions.

Another discussion focused on the complex timetable set at the multilateral and national levels for the phasing-in of financial regulations on capital, leverage and liquidity. Bankers feel that much has been done in terms of making the financial system safer but that regulators should not over-burden institutions by introducing new requirements.

There was a greater agreement on the thorny issue of bank resolution, i.e. the process of unwinding a troubled bank in the future. The principal lesson from 2008 is that there’s limited appetite amongst regulators to bail out banks with taxpayers’ money. Addressing the ‘too big to fail’ issue will therefore require a robust legislative framework that not only rules out bank bail-outs but also sets out clear guidelines on what categories of bond and equity holders will be bailed in.

The European Parliament is in the intermediate stage of putting together a single resolution framework which addresses many of these key challenges. As can be expected, there are differences in views (both within the euro area and the EU) on issues such as setting up of a single EU-wide resolution fund that will deal with bank bail-ins in the future.

Vilnius underscored the importance of strengthening regulatory coordination

While banks broadly agree with the over-riding objectives of the resolution issues, the dispute is in the details. At Vilnius, regulators emphasised that for bank bail-ins to be legally credible, they have to be based on the principle of no creditor being worse off. Regulators also want a certain degree of flexibility because it’s impossible to know the nature of the next financial crisis.

Banks are worried about a potential misalignment between how they are funded (with a mix of equity and bonds) and the future bail-in structure, which will determine how a failed bank will be resolved. Such a misalignment could be costly in a crisis situation as a failing bank will not be able to resolve itself.

Banks argued at Vilnius that the bail-in instruments had not been tested as yet and there were considerable risks to financial stability if the EU did not get this right.

If anything, Vilnius underscored the importance of strengthening regulatory coordination/cooperation and for banks to implement what their governments agreed to at G20 in 2009 and 2010 – to develop and put in place policies that deal with the fault lines exposed by the financial crisis.

The prize is a sound and more stable global economy with a healthy and supportive financial system.

For much of the post-1945 period, world leaders got the mix of macro and micro policies right, leading to an unprecedented period of growth and prosperity. At Eurofi in Vilnius, the consensus was that the global economic outlook needs to improve and that this requires learning the right lessons from the recent past.