Rethinking Bank Oversight

As discussions around bank capital requirements (re)gain momentum in the developed world, it is imperative for all stakeholders to reflect on the root causes behind this year’s banking failures. Past experiences suggest that incremental increases in capital ratios may pale in comparison to the long-term impact of cost-effective initiatives aimed at enhancing banking supervision.

Bank capital has once again taken centre stage in financial news this year. In late July, US banking regulators, spearheaded by the Federal Reserve, revealed plans to finalise the Basel 3 reforms, colloquially referred to as Basel 4 due to their substantial implications. The objective, as outlined in a joint agency proposal, is to enhance the strength and resilience of the banking system by adjusting capital requirements to better align with underlying risks and by introducing more transparent and consistent criteria.

The proposed reforms are proving to be more stringent than anticipated. They extend coverage to more banks, including those that had benefited from concessions during the Trump era, and mandate the inclusion of unrealised losses from securities in banks’ capital ratios, among other changes. Overall, US regulators anticipate a 16% increase in capital for the most complex banks.

The need for good supervision across the field

The spate of bank failures, commencing with the Silicon Valley Bank collapse in the spring, has emboldened US banking supervisors, led by Fed Vice Chair Michael S. Barr. However, despite the shift in political sentiment following these failures, there remains strong opposition to the new regulations. Figures like Goldman Sachs CEO David Solomon and JPMorgan Chase CEO Jamie Dimon argue that the rules may hinder economic growth without significantly enhancing safety and soundness.

This contention is not exclusive to the United States. The Bank of England has also proposed robust measures, with British banks, in contrast to their American counterparts, responding with a more measured tone. The debate is set to unfold differently in various regions over the coming months.

A recent working paper by the International Monetary Fund (IMF), titled “Good Supervision: Lessons from the Field,” highlights that European banks currently maintain higher capital ratios than their American counterparts. This might explain why the European Union’s Basel 3 implementation plans do not foresee increases on the scale proposed in the United States.

Crucially, the IMF authors argue that recent bank failures are not rooted in capital weakness. The Swiss National Bank’s observation during the collapse of Credit Suisse underscores this, stating that meeting capital requirements is necessary but not sufficient to ensure market confidence. The core issue was the lack of investor confidence in the bank’s business model and the rapid withdrawal of deposits, revealing a liquidity shortage rather than a capital deficit as the decisive factor.

US authorities’ reports on this year’s bank failures echo similar sentiments, attributing the problems to risky business strategies compounded by weak liquidity and inadequate risk management. Despite supervisors identifying these issues, they failed to insist on more prudent responses from banks when there was still time to act, according to the IMF authors.

Building on recent reviews by banking supervisors, the IMF authors draw broader lessons from post-financial-crisis reforms and their varied implementation across jurisdictions. They argue that an absolute shortage of capital is not a prominent weakness, emphasising that some countries apply Basel minimum requirements as a “one size fits all” rule without considering differential risks. The authors also highlight the underutilisation of the “Pillar 2” process, which allows regulators to require additional capital in cases of weak risk management.

The IMF authors identify more significant issues, such as a shortage of skilled staff in many regulatory bodies, the pressure on regulators to make politically expedient decisions, and inadequate attention to corporate governance and business models. Supervisors, they argue, have hindered themselves by allocating insufficient resources for overseeing small firms and adopting flawed internal decision-making processes.

The overarching conclusion from the IMF is that regulation, in the form of capital or liquidity rules, is seldom, if ever, enough. The quality of supervision and the competency of supervisors themselves are far more critical. This message is crucial for central banks and bank regulators worldwide as the debate over capital requirements intensifies.

Experience shows that minor adjustments in capital ratios or risk-weighted asset calculations may have a limited impact compared to cost-effective initiatives aimed at upgrading supervision. A cultural shift empowering supervisors to act on their concerns is necessary, and earlier interventions leveraging existing tools and powers could have prevented some of this year’s regrettable bank failures.

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