The financial industry is on the verge of radical change by technological innovation. The Internet of Things (IoT), Artificial Intelligence (Ai), Blockchain technology and its consequential inventions, like affordable international money transfer services as ‘TransferWise’, the cryptocurrency ‘Bitcoin’ and peer-to-peer crowdfunding networks, expand the approach towards risk by regulators. But that’s not all. The financial services industry also fights against reputational damage and decreasing profit margins.
In response to the exposure of deficiencies revealed in and during the recent financial crisis, an improved regulatory framework was suggested. Time does not stand still and therefore macroprudential regulation should adapt flexibility conveyed by a Fintech based future society with a focus on systemic risk.
Fintech slowly becomes the ‘new normal’. The result is that traditional banking services become expensive and cyber-security turns into a serious challenge. Financial institutions need a flexible framework where the balance between economic growth and regulation is warranted. This regulation however must be strong enough to secure the consumers interest and prevent a new economic meltdown.
Global regulators have the unappreciative duty to create a framework that works cross border, while at the same time respect the individual and domestic financial ecosystem.
This paper aims to provide clarity on the current international banking regulations and the impact the Basel Accords have on the financial industry. It demonstrates future challenges and opportunities, and offers practical recommendations to regulators who need banks and other financial institutions to cooperate with the implementation of new capital requirements for traditional lending activities.
The Basel Accord on Banking Supervision
Economic stability is the driving force to achieve sustainable growth. Banks play a crucial role in the world economy. The recent global financial crisis showed that market discipline alone will not deliver financial stability and therefore banking institutions need a regulatory framework that provides them with specific standards and requirements towards risk and regulatory capital. The Basel Committee on Banking Supervision (BCBS) aims to provide such a framework to be implemented by Central Banks and direct banking supervisory authorities.
Since its inception in 1974, the BCBS committee provided different international guidelines and standards. In the early days, the aim of the committee was to ‘close gaps in international supervisory coverage so that (i) no banking establishment would escape supervision; and (ii) supervision would be adequate and consistent across member jurisdictions’. Principles for shared supervisory responsibility for foreign branches of banks, subsidiaries and joint ventures were set out in a publication called the ‘Concordat’.
The Concordat was revised and re-issued and a Supplement was added in 1990. A Report, ‘The supervision of cross-border banking’ elaborated on the earlier papers and presented proposals for overcoming the impediments to effective consolidated supervision of the cross-border operations of international banks.
A logical next step after the release of the Concordat and Report was an agreement to regulate capital adequacy; ‘Basel I: the Basel Capital Accord’ was announced in 1988. The mismatch between foreign debt and domestic earning power in Latin America that resulted in a debt crisis, triggered the concerns about the exposure of international banks to international risks.
Basel I provided an international standard for the calculation of banks regulatory capital. Its objective was to ensure that banks held sufficient capital to cover credit risks; to describe and balance the playing field for international banks that compete cross border; and to facilitate comparability of the capital positions of banks. The format evolved over time and amendments were made.
In 2004, Basel II was introduced. Quality of risk management and supervision were the main focal points. The actual economic risk had to be acknowledged and banks were encouraged to enhance risk management and measurement competences.
The core drivers of the Basel II Accord, self-regulation and market discipline, were staged in three pillars: Minimum capital requirements (risk based); Supervisory review (additional capital requirements); and, Increased market discipline.
The Basel I and II standards indicate weaknesses in fundamental ways. A downwards snowball effect can be triggered by incentive based work ethics in combination with poor governance, high leverage and low liquidity buffers.
Due to the availability of low interest liquidity in the era before the Lehman Brothers failure and the (unfounded) confidence in the market, banks failed to implement liquidity risk management and based their calculations on future assumptions. Contingency Funding Plans did not always have links to tangible and related calculations. Updates for Basel II were suggested and the market risk framework needed revision.
The collapse of Lehman Brothers and its global, systemic impact demonstrated the need for additional measures. Lehman’s business model showed a strong dependency on the valuation of the housing market, the US subprime mortgage and real estate markets and financial mortgage backed securities, while offering employees a stimulatory financial incentive. Warning signs from the downfall of Bear Stearns a few months before, were largely ignored.
Although securitization can diversify and lower overall default risk, the execution of the process during the lag phase of the global financial crisis that started in 2008, was disastrous. Nearly all parts of the chain failed. The valuation of asset backed securities was inadequate and investors in synthetic collateralized debt obligations (CDO) were mainly investing in the performance of mortgage products and not in real or direct mortgages.
Securitization removes the loan from the books of a depository bank in the form of a CDO security. A bundle of loans, risks included, is sold to investors. The obtained liquidity can be used again to offer loans, bundle the loans in packages and sell them again to investors. Investors in these asset-backed securities are often non-bank financial institutions that participate in the shadow banking system.
The global financial crisis of 2008 intensifies the need for regulation. Banks appoint high skilled advisors to find and sometimes abuse loopholes in regulation. Off balance sheet transactions or accounting ‘tricks’ as the ‘Repo 105’ should be visible for potential investors to allow them to determine the risk involved.
Basel III announced new capital and liquidity proposals. Higher and better capital and liquidity standards are implemented in different stages to enable the banks to keep on lending and stimulate the economy.
Under Basel III bank liquidity should be increased and bank leverage decreased. The framework complements the first two accords and diversifies risk in different categories.
Different capital requirement calculations should enhance financial stability:
- ‘The leverage ratio, that includes off balance sheet items regardless of risk weighting, measures the banks value of equity.
- Banks need to fund themselves with an increasing minimum common equity capital ratio.
- A capital conservation buffer helps banks to build up capital buffers in times of prosperity to intercept periods of financial stress.
- The minimum tier 1 capital, the core capital a bank must maintain in relation to its assets, will be raised to 6% in 2019.
- The liquidity coverage ratio ensures that the bank holds enough high quality liquid assets to cover total net cash outflows over 30 days.
- The net stable funding ratio determines the needed amounts of stable funding to exceed the required amount of funding over a one-year period of extended stress.’
The capital requirements under Basel III enforce the financial stability of individual banks and maintain the confidence and enhance the general perception in the financial system. Therefore, a run on the bank initiated by the fear of failure is limited. However, there are more reasons for bank customers to massively withdraw their funds and the improved capital requirements under Basel III try to tackle the biggest challenge.
The capital and reform package as suggested by Basel III aims to avoid bank runs and eventually a systemic crisis. In the event the interference by a central bank is needed to safeguard the interest of all stakeholders, a resolution package can follow. The methods used to restructure the troubled bank aim to resolve financial institutions in an orderly manner without taxpayer exposure to loss from solvency support, while maintaining continuity of their vital economic functions. In general, restructuring takes place either by M&A, sale of specific assets, a forced takeover or when all other measures failed and the bank cannot be liquidated, nationalisation of the bank or a rescue mission with taxpayers’ money where the government acts as a lender of last resort.
While studying the Basel Accords, the rapid changes in the technological industry get little attention. The business model of banks will inevitably change. Never in time human generations had so few interconnectedness; millennials and digital natives, who grew up in an era where technology was the norm, have a different view on the financial industry. The Global Consumer Banking Survey 2016 reveals that 40% of bank customers are less dependent on a bank as primary financial services provider and already use non-bank providers. The Millennial Disruption Index shows that 33% of respondents believe that they won’t need a bank at all and that innovation will come from outside the industry.
Another issue is the confidence and trust the consumer has in the financial industry. The recent manipulation of LIBOR rates and consequential verdicts and settlements are substantial. The challenges Deutsche Bank experienced in 2016, seem to continue in 2017 with another scandal.
Regulation is not just a matter of improving capital standards; financial stability can have a broader context. The implementation of changes in the business model of banks, the function banks have in a trust based society and the impact cyber security has on the industry is far-reaching and should get a similar priority as Basel III.
The mechanics through which banks channel funds to the real economy
In general, economic growth is the result of the increase of the total value in goods and services produced. Growth is initiated by spending. Spending is possible when consumers are willing and able to use their money. Money can be generated by working for income, sale of possessions or by using credit.
When economic growth stops or even declines, central and federal banks try to stimulate spending via quantitative easing. The European Central Bank for example, purchases marketable debt instruments with her asset purchase programmes. The result is an injection of liquidity into the banking system. Banks can use this new available liquidity to provide individuals and businesses with credit facilities.
As we see in Japan, the monetary policy that includes quantitative (and qualitative) easing and negative interest rates, is not necessarily a way to revolutionize and stimulate the economy. There is no full certainty that these low, or even negative, interest rates stimulate spending because they could also encourage savings.
Under Basel III, banks need higher levels and different types of capital. This consequently has a negative impact on the reserve of the bank which is the basis for their lending policy. To restore the balance, banks need to attract more capital. However, competition, especially if there is few regulation, from Fintech based financial firms can make raising capital expensive. Peer to peer lending, crowdfunding platforms and on a different level, companies like Netherlands based Bunq, ‘the WhatsApp of paying each other’, splinter the landscape of financial service providers and can take market share away.
To reduce operational costs, banks need to avoid waste of capital and liquidity while implementing the Basel III requirements. Furthermore, technological innovation, specifically related to Blockchain technology, can decrease traditional costs.
Due to efficient workmanship and implementation of blockchain based techniques to qualify customers, and perhaps outsourcing of specific tasks to Fintech based intermediaries, banks can lower the price of loans.
Risk management becomes wider and more important. Traditional risk management includes business model risk, contagion risk, defaults and failures, and fraud. Cyber security and IT related developments bring risk management to another level. The heist at the Bangladeshi central bank in 2016 where 81 million USD disappeared and the data hack at JP Morgan, one of the largest bank hacks in US history, clearly express the need for high quality protection. The complementary changes needed to implement new security measures, while monitoring the traditional risk factors, have an impact on the short-term profitability of the banking sector. Therefore, changes in the current business models are essential to survive.
With a limited availability of funds, rules to get loans approved get stricter. It is possible that on the financial side, the lender requires more collateral, provides lower loan to value, wants the customer to bring own funds, or other means to build a strong loan portfolio. The default risk can be lowered by stricter norms and more reliance on credit rating. Also, terms for loan agreements can change. Scarcity and a high demand raises the price of the loan, and a minimal default on the payment terms can result in the loan being repayable on demand. The consequence is adversely to the function that a banking institution should have in society; converting future income to current spending, therewith, retail banking plays a crucial role in fostering economic activity.
Small business owners and consumers with poor credit, fluctuations in their income or in need of subprime financing, face difficulties raising funds when there is a limited availability of fresh capital. They either try different sources to get funding or stay behind. The latter enlarges the gab in society between the upper side and the lower side. The financial industry and the real economy are more interconnected as ever. Specifically, governments have a moral duty to prepare the population for drastic changes in the labour markets. The absence of pre-reintegration programs will raise unemployment, creating a downward spiral; it’s a vicious circle.
Deficiencies in banking models
The reliance on self-regulation and market discipline is not sufficient to protect the industry from the inside. Banks and other financial institutions will always look for maximum profitability within the regulatory framework. Therefore, the capital requirements in Basel III are understandable when we focus om default risk. However, we cannot ignore the economic impact stricter capital requirements have on the economy.
The Basel III framework suggests to build extra layers of capital. The coverage is needed to prevent bank runs and bank failure. The gap between economic theory and practical implementation leaves clues. In a world that is in political turmoil due to a possible Brexit, a radical new approach in the USA and the upswing of right-wing populism in Europe, economic stability is necessary.
Home ownership ensures less dependency on public support. In 2002, the Bush administration initiated the American Dream Downpayment Act, followed by incentives and the idea that a free market with few regulation leads to prosperity. From the funding side, different mortgages were bundled in packages. These packages were sold and new liquidity was created. The securitization process got blurred overtime, because the pool of bundled mortgages could not be realistically valued. Credit rating agencies played a dubious role in the valuation of mortgage backed securities.
Banks need to securitize their loans to have a constant flow of fresh capital. The default risk as exposed during the global financial crisis must be avoided. Rating agencies should be less dependent on firms paying for their own ratings, avoiding a conflict of interest. Subscription based payments or government support might create this independency. The possibility that consumers with low credit rates and institutional investors are excluded from the standard asset backed securities and thus getting their own pool is something worthwhile to investigate.
Regulation, security, confidence and profitability can go hand in hand when efficient collaboration between domestic, and in some cases international, regulators and the industry is warranted. Central banks use their supervisory powers to streamline regulation towards banks and their peers. Financial services authorities monitor the competency of the employees and their fair practices. Rating agencies should provide an un-biased high quality view on risk to avoid a mismatch in price and value. Intermediaries ought to be used in the banking process to market products, deliver affordable money transfer services or assist with due diligence. Third parties, like peer to peer lending and crowdfunding platforms can be integrated to diversify risk and create a lower loan to value ratio by the bank. Financial institutions should benefit from all opportunities described.
When banks have limited availability of disposable capital and raise their prices, consumers might start looking elsewhere for financial services. Governments can slow down or ease this process by offering guarantees for small business owners and future home owners. Also, a government backed incentive scheme for microcredits and peer to peer lending can get the pressure of banks during the tradition phase.
Capital and liquidity reformations encourage a diversity in lending possibilities. Low risk weight assets have higher leverage possibilities and banks will want to focus on attracting this type of capital. IT platforms that work outside the banking frameworks, cannot engage in fractional reserve lending and cannot use a money multiplier. Non-professional investors who find in crowdfunding platforms like ‘Lendingclub’ an alternative to generate return on investment gain more momentum overtime.
Efficiency, stability and risk (default) management become the core drivers under Basel III. Financial institutions can start to think about outsourcing specific high cost, low revenue tasks to Fintech based firms and financial intermediaries. Marketing and sales but also customer due diligence can be, even partially done by others.
Practical recommendations for regulators
These are challenging times for regulators. The fast-changing IT landscape, political fermentation, slow economic growth, and the overall emotional sentiment towards the financial industry, all have an impact on the economic stability. For example, Donald Trump recently announced his ideas to put a halt to the Dodd-Frank Act, meant to regulate the financial industry further. Connection to the internet via smartphones and tablets grows in 2017 to 2.3 Billion users worldwide. These are just two examples that will have an impact. Regulators need to be flexible and base their standards on easy and fast implementation and change if needed.
The new Basel requirements for banks can boost the market for peer to peer or network based lending. Different models to determine default risk on loans with information from different data sources that show evidence of past behaviour are already used by small business lender ‘Kabbage’. Allowing banks to implement similar technology or encourage them to outsource can shift the banking landscape to more custom service.
A reasonable response to stricter credit rules is that specific industries have difficulties to continue their credit lines. Also, industries facing economic downturn might experience difficulties following the new rules. A guarantee system for either periodic default or mandatory insurance based warranties can stimulate lending.
The advantage of strict rules for small business loans is that entrepreneurs need to work on building a stable company to be granted such loans. Business failure can have many reasons, and a publication from the US based SBA states that about half of started small businesses are still operational after five years. A risk that cannot be downplayed by funders.
The consumer market can be stimulated in a similar way. The Dutch ‘Nationale Hypotheek Garantie’ is a government guarantee for consumers willing to buy their first house. The guarantee lowers the interest rate during the fixed interest period. Due to lower interest, home ownership becomes affordable for more consumers. In France, future homeowners can apply for a ‘cautionnement bancaire d’un crédit immobilier’, which is an insurance in case of default on the mortgage. The guarantee is managed by the banks in a mutual fund to cover default risk. Similar models, or even a direct copy, can be implemented by many governments.
The subprime market, which was at the core of the recent global financial crisis, should exclude real estate investors and second mortgages. A subprime mortgage might only be available for the house people live in and the maximum loan should not exceed the value of the property. Another suggestion can be to issue a mandatory deed of assignment from the home owners income directly to the lender to safeguard the periodic payments.
A complete uncultivated area is financial education of the population. Access to the internet can make an expert of everyone. Unfounded information is available everywhere. Education of the public about financial products can protect customers against malpractice in the financial industry. Few thorough studies are available on governmental and regulatory portals. A compelling strategy to let consumers acquire a mandatory license before they purchase a financial product can protect the customer from top-down. Additionally, small business owners can be trained to search for additional funding sources while understanding the pitfalls of inventive fundraising strategies.
Globalisation and migration change countries. European and American standards differ from African or Islamic rules but also migration has its own implications. Applying for financial services is for new inhabitants without credit history difficult. The bank cannot always do its due diligence properly. A global unilateral setting is not easy to introduce because not every country can implement one and the same legal framework. A balance between risk, regulation and socio dynamic factors must be acknowledged.
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