Have Financial Stability Proposals Been Implemented Properly?

Philip Arestis and Malcolm Sawyer

Many countries have developed policies to address financial stability since the Global Financial Crisis (GFC) and the Great Recession (GR). How far these policies have been fully implemented and how far those policies can contribute to avoiding the next financial crisis, or mitigating its effects, are interesting questions.

The focus of policies to ensure financial stability should be on proper regulation of the financial sector. Proposals that aim to ensure financial stability have been put forward and we briefly comment on them. The main proposals are the US Dodd-Frank Act, the UK Vickers Report, the European Liikanen Report, the IMF Report, and the Basle III Report.

The most important is probably the Dodd-Frank Act, which was signed into law on 21 July 2010. The rule contains a number of important constituent elements; the most important is the elimination of proprietary investments (namely to prohibit banks that take insured deposits from running their own trading operations) and also ownership of hedge funds by banks. In the final Act this was modified so that banks would be allowed to hold proprietary investments of 3 percent of their core capital.

The Financial Services Forum (FSF), which represents the 18 US top banks, has argued that the Dodd-Frank Act proposals misdiagnose the causes of the financial crisis. The proposed elimination of proprietary investments, they claim, is too complicated and too costly to achieve; the proposals put jobs at risk, damage US competitiveness, and might even threaten growth in the US economy.

More recent developments have emerged. The current President of the US has repeatedly suggested that the Dodd-Frank will be repealed. This, in his view, is simply because the Act has prevented banks from providing credit where is needed. In fact, the President ordered a review of Dodd-Frank in early February 2017. The House of Representatives voted in early June to replace the 2010 Dodd-Frank Act with their own sweeping financial regulatory bill, the Financial Choice Act. The focus of the Choice Act is to repeal the Dodd-Frank’s elimination of proprietary investments. The US Treasury released on 12 June 2017 a report on financial regulation reform. The report suggests that the current system of excessive financial regulations has undermined the ability of banks to provide credit to account for the needs of the economy; and has constrained economic growth. Although it does not reject the Dodd-Frank Act proposals, it recommends that they are applied with less rigour, more discrimination, and greater consultation with the industry.

The US initiative and proposals have been followed by the Bank of England. A government-appointed commission on banking was set up in the summer of 2010 to provide a year-long analysis of whether banks should be split up into commercial and investment entities; and whether a version of the Dodd-Frank Act is appropriate for the UK banking. The Vickers Commission, as it is now known, produced its final Report in September 2011. It recommends “ring-fencing” banks’ retail operations from their investment banking activities, whether conducted by UK or foreign-owned banks. It thereby aims to protect retail banking activities from losses incurred in investment banking operations. There are problems with the Vickers Report. The main problem of ring-fencing is that banks may be encouraged to take greater risk with the activities inside the ring-fencing, such as mortgages, corporate and personal assets. There is a provision in the bill that would allow split of individual banks if the ring-fence is not followed properly.

Another problem with the UK Vickers Report is that the regulators are concerned that banks may fail to meet the 2019 deadline of their ‘ring-fencing’ retail operations from their investment banking activities. Vickers (2016), who chaired the Vickers Committee, argues that the BoE has not adopted the recommendation that banks should ring-fence extra capital equivalent to 3% of their risk-weighted assets (RWA), the systemic risk buffers. The BoE suggests that 1.3% would be sufficient.

A similar trading ring-fence proposal comes from the Committee commissioned by the European Commission and headed by the Governor of the Finnish Central Bank, Erkki Liikanen. The committee suggests ring-fencing banks’ trading business, not of retail activities as in the Vickers report. Ring-fencing trading assets, though, would limit the liquidity of corporate bond trading, thereby making this form of financing more expensive.

The 27-member countries of the International Basel Committee on Banking Supervision of the Bank for International Settlements with the Group of Central Bank Governors and Heads of Supervision at their meeting on 12 September 2010 reached an agreement on regulatory issues; further discussion took place at the first 2011 G20 meeting in Paris. The so-called “Basel III package” is concerned with bank capital and liquidity standards. The new ruling, phased in from January 2013 with full implementation to be achieved by January 2019, has only dealt with bank capital. It requires banks to hold equity requirements to 9.5 percent of the risk-weighted assets (RWA); and a liquidity coverage ratio, which requires banks to meet a 3% leverage ratio.

A serious problem with the Basel III proposal is that it has failed to achieve agreement on its key risk measure. The countries involved could not agree at their meeting of November 28-29, 2016 on the definition of the RWAs. Another postponement took place subsequently of a relevant meeting on the 7^th/8^th January 2017. Clearly, then, Basel III has failed to correct the mechanism through which the main cause of the GFC emerged.

Under such circumstances it should not be surprising for another similar crisis to take place. All in all, and given the key role of Basel III in the global regulatory system, it would appear that financial stability remains unresolved and elusive.

Clearly, progress on financial reform, is extremely slow; and worrying poverty of action. In fact, seven years since the Dodd-Frank Act of July 2010, which is now substantially regressed, and the banking reform remains a work in progress across the world.

References

Vickers, J. (2016), “The Systemic Risk Buffer for UK Banks: A Response to the Bank of England’s Consultation Paper”, LSE Financial Markets Group Paper Series, Special Paper 244, April.

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