25 July 2016

Financial Times: Bank regulators, be careful what you wish for

The Bank of England’s announcement that UK banks can reduce the “rainy day” capital they had previously been asked to hold — as a countercyclical buffer — is a welcome piece of regulatory dexterity in a Britain that may be entering recession.

While many fear the economic harm from Brexit, the new storm is likely to be caused by the longer-term effect of the latest proposals from the Basel Committee on Banking Supervision, the global bank regulator, and this may prove more damaging to the economies of Europe. [...]

This latest Basel initiative is different. It is again asking banks to hold much more capital than they do today but is focused on traditional lending activities. These are just proposals — the industry’s response has been ferocious and there will be the usual negotiation. There is little doubt, however, that what finally emerges will result in capital requirement for lending activities going up and hence profitability going down.

Unlike previous high-profile retrenchments in the investment banking sector, it would be politically hazardous for a leading bank to announce plans to reduce lending to the real economy. Equally, though, it would be naive to think there will be no strategic response to the Basel recommendations. Banks do not have the luxury of absorbing further hits to their profits.

That does not mean regulators should simply abandon their plans to raise capital requirements for lending to the real economy. The rules covering these loans were crafted in the early 2000s and the financial crisis undoubtedly highlighted deficiencies in their models that need to be addressed.

However, regulators should be realistic about the effect that these rules will have. If the return on equity from mortgage lending or corporate lending falls by more than half — as has been widely estimated under the proposals as drafted — then banks will either ration lending in these areas or try to raise prices. Doing nothing is not an option.

What regulators and policymakers in Europe need to focus on instead, therefore, are the consequences of these proposed rule changes. Their priority should be developing financing solutions other than banks from which customers can borrow.

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