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Banks: regulating the future

The eurozone countries have agreed to set up a single supervisory body (SSB) for banks. It is expected to adopt common criteria to enable it to carry out a harmonised supervisory role in so diverse an area with large and small economies and small and large banks, which would include the 25 licensed banks in Malta.

How can a regulator regulate against bad judgement?
- Joseph Pace Ross

Surely, the SSB will draw on the proposals of the Liikanen Report, published on October 2. This report was commissioned by Michel Barnier, the European Commissioner for Internal Market and Services, to reform the structure of the EU banking sector following the crisis in the financial markets.

This high-level expert group, composed of 11 experts, is chaired by Erkki Liikanen, Governor of the Bank of Finland and member of the governing council of the European Central Bank. It is proposing a set of five measures that augment and complement the set of regulatory reforms already enacted or proposed by the EU, the Basel Committee and national governments.

The first measure and, apparently, the main thrust of the report is its proposal for banks to assign to a separate legal entity their activity in propriety trading and other significant trading activity such as real estate. This legal entity will be on a stand-alone basis separate from the deposit-taking bank. In other words, the measure distinguishes commercial from investment banks, which will have to fund their activities from sources other than short-term deposits or loans from commercial banks.

The concern of the Group leading to this proposal can be found in the body of the report and, particularly, in the frequent references to funding mismatches. Thus, according to the report, “the analysis conducted revealed excessive lending in real estate markets coupled with funding mismatches and over-reliance on wholesale funding in the run-up to the financial crises”. Also, “taking short-term deposits and granting longer-term credit is prone to bank runs”.

The group is therefore proposing, in order to address funding problems arising from asset-liability maturity mismatch, to introduce a net stable funding ratio requiring banks to match their assets (loans) by sources of funding with similar maturities (customers’ deposits).

Now this is nothing new. Following the Great Depression in the US, the Glass Steagall Act of 1933 had prohibited commercial banks from engaging in investment banking. There followed some 66 years of relative financial peace until this law was repealed in 1999. Many feel that this eventually triggered the sub-prime mortgage crises in 2007 and all the turmoil and bailouts that followed. The Dodd Frank Act, referred to as the Volker Rule, had the same objectives as the Glass Steagall Act.

The probity in having commercial and investment banking funded separately was not lost on us in Malta. In 1968, Barfincor was set up to siphon off long-term lending, mainly mortgage loans, to this entity. In 1976, the Investment Finance Bank was set up with parallel objectives for industry. However, as was the fate with the Glass Steagall Act, the two companies were phased out of the scene.

Excluded from the separation requirement are the so-called universal and small banks. Nonetheless, the local regulator would do well to take into consideration the size of the economy and the relative importance and impact of local small banks on the local scene since what is small in the broad eurozone area is not necessarily so here.

The social impact of the failure of a small bank in an economy of our size can have long-term consequences as can be seen from the National Bank and Bical sagas. We must not forget that many of the 25 licensed banks in Malta tout for deposits from local residents. In view of this changing scenario, perhaps some fine-tuning on how banks can apply their depositors’ funds may be desirable.

This segregation directive, if it is adopted by the Commission, looks prima facie rather restrictive but it may also have beneficial effects both for depositors and for the banks. Runs on banks can be kept at bay, at least theoretically, while the possible consequential emergence of new or subsidiary investment banks would create fresh investment opportunities for small shareholders in a better regulated financial climate.

Entrepreneurs with capital projects requiring long-term finance would be able to find a more sympathetic ear at an (investment) bank free from worries of matching maturities. Perhaps this directive could also indirectly generate more activity on the Exchange . We have to wait and see.

There are other recommendations in the report. The Group is proposing to augment existing corporate governance by strengthening boards and management. Particular concern is expressed on whether the banks’ boards’ mode of operation, which included challenge to the executive, was effective enough.

In one particular case it asked whether the board received adequate information to consider the risks associated with the proposals and whether it sufficiently questioned and challenged what was presented to it. Essentially, it concluded that pre-crisis regulation and supervision was inadequate.

What probably led to this last recommendation was the fact that, in the case of those banks that failed or came to grief, neither the internal audit nor the external one, nor the boards themselves, nor the national regulator (the Securities and Exchange Commission, in the case of the US) saw what was coming and, therefore, did nothing to prevent it until it was too late.

Of course, the depositors paid the price or, in the case of banks too big or too systemic to fail, the taxpayers did so.

Whether or not the Commission will accept the report or parts of it is not yet known but it seems likely that a spate of new directives will follow in the near future from the SSB in an attempt to avoid recurring turbulence in the banking sector. All this might have positive effects but, in reality, a wise and prudent banker does not need all these regulations to conduct his business in an orderly manner in the interest of the shareholders and of the depositors of whose hard-earned savings he is the trustee.

What is lacking is not so much further regulations but experience and traditional values that society seems to be allowing to fall by the wayside as the failure of banks abroad have shown. Having said this, banks need a measure of good judgement to rely on.

So, however praiseworthy the initiative of Commissioner Barnier may be, there remains one major problem: how can a regulator regulate against bad judgement?

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