June 8, 2016    4 minute read

Bank Regulation And Misinformation

   June 8, 2016    4 minute read

Bank Regulation And Misinformation

Bashing bankers is a scapegoat for misinformation. The world has become obsessed with making banks smaller, reducing their risk profiles and limiting bonuses, to name three of a seemingly never ending list. But fundamentally, what is a bank’s role in society?

A bank engages in maturity transformation, which is they take short-term savings and let out for the long term. The model works as long as trust is retained and the banks solvency is not called into question. Investment banks are there to facilitate capital raisings for governments, public sector assets like hospitals and large infrastructure projects and for the private sector in obtaining the optimal bespoke deals they require.

The first wave of the crisis was due to Fannie Mae and Freddie Mac; both of which were mortgage institutions, not banking entities. AIG then followed suit from selling credit derivatives to investors, again not a banking entity. Since the crisis, there is virtually no SIV’s, no subprime mortgages, no off-balance sheet vehicles, no CDO’s and no exotic derivatives in the system. Bank capital is twice as much capital as before, and not all banks required a bailout. Furthermore, some banks helped out by acquiring struggling banks and helping government issuance in Europe, particularly in Italy and Spain in the depths of the Euro crisis. They could do that because they have sound business models, which some commentators are too stubborn to believe.

The banking landscape is completely different. Regulators have decided that banks should de-risk, reduce leverage and should no longer provide market-making business, which is act as the middleman between buyers and sellers. The result? Larger volatility and a decrease in liquidity.

If the banks and government agencies are not providing this function, what’s the solution? Putting nothing in place creates a vacuum. We have witnessed mass volatility in the US Treasury and the German Bund markets, yet regulators and policy makers are still sitting idle, even though we are listing off instances of tantrums occurring in bond markets. It is an irresponsibility to do nothing. One solution is to let the central bank do it, but that begs the question, for the UK at least: should Brazilian corporate bonds be on the Bank of England’s balance sheet? Sounds comical but frankly that would be safer than doing nothing. Simply getting rid of a valuable function to make banks ‘safer’ has only made the marketplace riskier and more volatile.

On the regulation side, a more cohesive regulatory structure is needed. The Basel set of capital requirements requires banks to hold a certain level of equity capital to ensure against large losses and to prevent future bailouts. The banks, therefore, have to go out and raise this new capital to plug these holes. The problem occurs when the largest bank investors, insurance companies such as Prudential in the UK, are being told under their set of regulations, Solvency II, that they cannot hold bank assets. Again, who will provide the gap? Investors? Why would an investor buy bank stock if they know when liquidity dries up, as was the case in 2007/2008, there will be no one to take the other side of the trade? It all connects but each regulation is so focused on their set of rules; they can’t see the wood from the trees.

And finally, European banks are in the worst situation, but the question is, why? EU banks bought too much sovereign debt. Who made them buy this debt and who is not in a position to service this debt?

Politicians need to think twice before they point the finger and before bashing bankers, need to maintain their fiscal houses and realise that banks are the solution while politicians are the problem.

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