Re-inventing Banking Regulations

Commodity, Stock and Currency markets are not really at its best now. Investors are worried that Greece may not be able to meet its obligations. They also feel that Spain, Portugal and Italy may also find it a bit tough to service their debt. Portugal, Italy, Greece and Spain (some call this group “PIGS”) may unsettle Eurozone and therefore, EUR is on a retreat.  Commodity and Energy prices are also hit by melt-down in risk assets.

All this is furthering of financial flu which world suffered from in late 2008 and whole of 2009. Debate about the root cause of the financial crisis has raged over a year. There is now some consensus that an overly accommodative monetary policy and ineffective banking regulation were the prime reasons for this sorry state of affrais.

It appears that new rules for banks are on its way. The Governments world over, have spent trillions of dollars to bail out the banks and are wiser now. They have risked rising inflation, taken on huge debt and had to suffer public hostility. They do not want a repeat.

In a nutshell, the Governments want to impose controls on banks, mainly to limit speculation. This will, perhaps, be welcomed by all. No bank is saying “Do not regulate me” for the fear of cutting off any bail-outs it may need in future. But they are saying that such regulations are a bit heavy handed and there is a risk of choking off a gradual recovery. The recently concluded World Economic Forum at Davos, Switzerland saw the battle lines between the Governments and the banks being drawn. But this was not on Forum’s agenda, but did become a significant issue.

What is preventing immediate clamp-down on the banks is lack of agreement amongst developed countries on what to regulate and how much to regulate. One should not also lose sight of the fact that it is a bit too easy for banks to circumvent the regulations. In this era of globalization, lack of uniformity in banking regulation may see banks indulging in “Regulatory Arbitrage”.

The talk is now centered on (a) bringing in restrictions on banks in undertaking own account trading (i.e., speculating by committing their own capital) and (b) discouraging banks from investing in private equity, hedge funds and some other similar alternative investments space. But is this going to serve the purpose of preventing another bail-out? It is debatable.

First we need to know why such a bail-out was critical. It was because they were financial institutions which were too big to fail and any failure of such big institutions would have crippling impact on the economy. There, we have the first regulation required – Do not allow any institution to grow to be too big to fail.

The drying up of liquidity was another reason for the crisis. The regulations should aim at banks maintaining higher level of reserves and lower level of mismatches between their maturing assets and maturing liabilities.

One more rudimentary thing is managing concentrations which are mainly (a) Economic Sector and (b) Product apart from (c) geographic concentrations. Too much of exposure in a few products or economic sectors is a recipe for disaster. Regulations should strictly enforce restrictions on concentrations in exposures of banks.

The banking regulations will, no doubt, be re-invented soon. We can only hope that such re-invented regulations will make this world a economically safe and sound.

2 thoughts on “Re-inventing Banking Regulations

  1. Hi Satish Rao,

    Nice to see your blog. Very informative. In fact I never visited any blog and yours is the first one. After seeing your photo I vividly remember seeing you in Shillong and there is only a slight change in appearance.
    Wishing you all the best.

  2. Hi Satish, I read the blog with interest. It is indeed insightful and contemporary. There are a couple of things that come to my mind. One is the regulatory arbitrage being unavoidable as impact of the crisis has been differently distributed relative to the resilience of various economies. Economies with relatively lesser impact of crisis on them, will perhaps be in a better position to calibrate changes in regulation. Secondly, I think that the exit strategies are going to vary as bail outs have led to certain imbalances in the capital markets and also inflation reckoned as a threat in so many ways. As the Governments grapple with dilemmas in terms of bail outs, there is a parallel concern arising from PIGS and the like, as you have well highlighted in the article. One fall out of the crisis is a better cooperation between Governments and a kind of collective resilience between regulators. They appear to be heading towards fundamental changes in subjects like systemic risk. As the stakeholders in the financial system are now significantly political stakeholders and tax payers, I feel it will take quite some while for the bankers to find peace with the aggressive postures from policy makers and political leaders who are equally frustrated in fixing the problem. Overall, I enjoyed your blog. You have a great scholar in you. I recommend to you to work on a thesis for a doctorate. My best wishes, Gopalan Parthasarathy
    PS: I wish to post this blog with acknowledgement of resource in xtrabloganza my blog dedicated to reading i liked.

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