2009 Reports

Towards Basel III? Regulating the Banking Sector after the Crisis

Davies, Phil

A roundtable discussion took place in Brussels on October 12, 2009 with the aim of producing concrete proposals on how banking could be reformed to prevent a systemic collapse on the scale witnessed almost exactly a year before. The current crisis represents a one-off opportunity to reshape the banking sector and impose a degree of control over it that will, discussants hoped, reduce future danger to the financial system and help set the global economy on a path to sustainable growth. A consensus emerged about the key elements of the banking crisis and how they should be addressed. Discussants agreed there was a compelling argument for regulation given the societal damage -- lost jobs, housing delinquencies, impact on Small and Medium Sized Enterprises (SMEs), impact on developing countries -- that the crisis has caused. Joseph Stiglitz, Co-President of the Initiative for Policy Dialogue at Columbia University and Nobel Prize Winner, remarked that Adam Smith's belief in the ability of markets to allocate capital correctly appears flawed. "The reason that the invisible hand of markets seems invisible is that it is not there," Professor Stiglitz said. However, the visible hand of regulation, such as Basel II, also failed to prevent the crisis. Regulation across the board has failed largely because it has not been in the interest of politicians, companies and individuals to encourage strong supervisory powers. A majority of discussants thought that regulation should now be comprehensive across countries and institutions. A crucial aspect of any new regulation should be counter-cyclical measures, meaning that financial institutions increase balance sheet capital during the upswing of a cycle and draw on this capital buffer when the economy trends down again. Regulation should not only focus on the capital structure and liquidity of banks but should impose detailed restrictions on risk-taking, including rules on incentives. Some, but not all, discussants believed there should be a tax on transactions to reduce volumes and, consequently, the fees paid by companies in the real economy. But a positive -- rather than merely restrictive, agenda should be applied in the setting of regulation to ensure that elements crucial to future growth -- such as SMEs and emerging markets -- receive capital that is diverted from less useful applications. Some roundtable participants were concerned that the desire for regulation will wane if the economy continues to recover. The reform agenda must not be allowed to slip or the next crisis will not be far away, argued Poul Nyrup Rasmussen, President of the Party of European Socialists. "There needs to be strong leadership; we need to regulate now," he said. The danger is not that new regulation will stifle the nascent recovery, as the banking lobby argues, but that under-regulation will create future systemic risks. Discussants acknowledged that regulation may not always find its target, but dynamic regulation can ensure it constantly evolves to meet changing requirements. Regulation should also be robust, applying a multi-pronged approach to each problem, even if this adds complexity. While global regulatory co-ordination was seen as desirable by many discussants, in practice it is unlikely to take place. Therefore, each country or political bloc should not wait for others to act but protect their citizens from unsuitable, externally-sourced products by regulating their own financial institutions.