DON´T PUNISH THE BANKS THAT PERFORMED BEST / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Don’t punish the banks that performed best

By Jacques de Larosière

Published: March 3 2011 23:25


The Basel III framework was designed to make the banking system more resilient. Perversely, it may create new risks by favouring the development of the insufficiently regulated shadow banking system and by penalising a diversified universal banking model that proved resilient through the crisis.


Moreover, there seem to be no significant measures to enhance the supervisory function, which appears more important in preventing banking crises than regulation itself.

The first contradiction results from the co-existence of a vast, less regulated shadow system with an increasingly regulated banking sector. The “originate and distribute” banking model that was the source of the crisis has, rightly, been contained. Securitisation has been considerably reduced, for market as well as regulatory reasons. In the US, banks must comply with the “Volcker rule” and are legally prohibited from engaging in proprietary trading or holding hedge funds and private equity funds.


But these activities remain attractive to many investors. There is thus a temptation to shift them to the shadow banking system, which can expand with little constraint. The only logical answer is to submit the shadow banking system to regulation and capital constraints. Regulators recognise this conclusion (under the Dodd-Frank Act “non-banks” can be declared systemically important and dealt with as such). But they stress the practical difficulties of such an approach. Nothing seems to have been done, although the Financial Stability Board is working on the problem.


The second contradiction concerns Europe in particular. The banking model prevailing in continental Europe is that of diversified “universal” banks with portfolios including retail lending, corporate loans, project financing, investment banking and fund management. Such banks usually keep their loans on their balance sheets and do little in terms of securitisation. This model is well suited to the way the European economy is financed: almost three-quarters through bank intermediation.


With the exception of certain institutions in Switzerland, Germany, the Netherlands and the UK that excessively inflated their trading books, these universal banks have proved resilient through the crisis. Given their central role in financing the economy and their modest recourse to securitisation, they have large balance sheets. But they are also well endowed with large deposit bases that strengthen their liquidity.

However, the high levels of capital that result from Basel III (requirements have on the whole quintupled) and the additional amounts that are in the process of finalisation for systemically important institutions (not to mention the new liquidity rules), will penalise universal banks.


The need for traditional European banks significantly to raise their own funds will carry two consequences. Given the cost of capital and the race for deposits, they will have to increase the price of their lending, making credit more expensive. Second, there will be a tendency to reduce lending so as to act on the denominator of capital ratios, and to shorten lending horizons. Banks will be tempted to keep on their balance sheets the most profitable but risky assets.


The third contradiction concerns the respective roles of regulation and of supervision. We all know that the extreme weakness of supervision – especially in countries that adopted the “light touch” approach – was a large factor in the crisis. Of course, regulation was far from perfect and it is in need of reform. But if controls had been more effective (as in countries such as Canada, Italy and France), the worst could have been avoided. It is no coincidence that the map of supervisory inefficiencies covers almost exactly the map of banking failures.


In spite of that, most authorities have concentrated their action on regulation, not supervision. But introducing more and more complex rules will not do much good: it will merely encourage shadow banking and regulatory arbitrage.


Even if the Group of 20 leading economies have recently mentioned supervision in their communiqués, one does not see much happening on the ground. The new European authorities in particular have a lot on their plate. They will need to be equipped with sufficient resources and independence in order to generalise internationally the best supervisory standards and practices. The role of the FSB in developing supervisory policies and the International Monetary Fund in monitoring compliance with them will also be crucial if we are to create a level playing field.


The writer is president of Eurofi, the European think-tank dedicated to financial services


Copyright The Financial Times Limited 2011