Too Big to Fail Isn't Too Clever to Regulate

With debt driving the economy, banks have become powerful. They often use their influence to chip away at the curbs imposed. Regulators need to be better equipped to make them toe the line

- SATYAJIT DAS

Stricter banking regulations known as Basel 3, introduced after the 2008 financial crisis to strengthen the global financial system, are now being systematically weakened. Understanding how regulatory 'sausage' is made gives insights into the problems.

Banks facilitate payments, accept deposits and provide credit and risk management tools. Deregulation and the drive for size and profitability have led banks to expand into underwriting securities, insurance, asset management and trading.

The risk of banking is simple. Unlike funds, banks guarantee the return of deposits. Losses from loans or other activities can jeopardize their ability to meet obligations. High leverage (10-12 times) exacerbates this risk. Banking involves maturity transformation. Deposits have shorter maturities than assets, meaning simultaneous large withdrawals create liquidity risk. Mismatches of maturities can expose the bank to rate fluctuations.

These risks can be addressed by less leverage with banks holding more capital, maintaining liquidity reserves and reducing maturity mismatches. Riskier activities, especially trading, can be restricted or supported by high levels of shareholder funds. Basel 3's attempts to do this were unnecessarily complicated.

Equity, which encompasses many types of securities, is supplemented by a separate leverage ratio. Capital calculations often require arbitrary and subjective differentiation between risks. Banks must meet a liquidity ratio and net stable funding ratio. For off-balance sheet instruments, like derivatives whose risks are difficult to estimate, there is a bewildering mix of central clearing, collateral and counterparty risk charges. Trading exposure is measured by complex formulas. Proprietary trading is theoretically restricted. Banks must prepare 'living wills', a funeral plan for unwinding transactions in the event of failure.