Capital Regulation: How much is too much?

Monday, 28 July 2014 00:03 -     - {{hitsCtrl.values.hits}}

In recent years the area of capital requirement has captured immense interest, as an “ideal” level can never be imposed, leading changes in the regulation ever so often. The situation being relevant for almost all countries around the word, including Sri Lanka, which strives to have a healthy financial and banking sector, the Central Bank (CB) facilitated a seminar last week to shed light on the topic. Exploring the topic ‘Capital Regulation: How Much is Too Much?’ the seminar featured Reserve Bank of India Governor Dr. Raguram G. Rajan to deliver a top briefing to a high profile gathering at the CB head office. Capital requirement, also known as regulatory capital or capital adequacy, is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded on the assets side of a firm’s balance sheet. Why is capital requirement an important issue? This being an area Central Banks from around the world spend lot of time in, Rajan noted while it may seem highly technical at first, going deeper one may realise the implications it has in the political economy of our times. With the attention to capital regulation having come after the great financial crisis where banks fell into a lot of trouble due to the bad decisions they made, the question is how much of the trouble was attributed to capital and how much was because of other reasons, is an imperative one to give answers to. “A lot of the focus in recent times has been on how we ensure our banks never get into trouble again and it is being driven by a variety of forces. First of all, regulators have a national interest to see that the banks don’t get into trouble and have the right assistance. There is also a lot of anger from the public, especially in countries that went to the brink, such as the UK where the banks were bigger than the economy and that led them to the point of disaster. “Soon after, when the banks started making money again, the broader question was why no harsh legal action was taken against the banks that failed to do the right thing and why it is the public that has to pay the price for this,” he told he told a fully packed audience that consisted of Governors of the South Asian Association for Regional Cooperation (SAARC) countries, leaders from the local financial sector, economists, and CB officials. When looking at the cases that are being filed against the banks, authorities have found it hard to find evidence of criminal behaviour. Not because there haven’t been any, but largely because the major contributors to the situation were bad incentives and behaviour. As a result all the banks had to do to get out of the situation was to pay huge fines imposed. “How else can the bank be penalised? Over and above the regulatory incentives is a political economy driven by the public and every one looking for some kind of scapegoat,” said Rajan.     Learning from the past? A number of proposals had been put forward to addresses the issue and one was bringing banks down to size, which limits its growth beyond a certain point. However if this solution is exercised it will lead another issue which is having too many players in the sector. “The other solution is to restrict the activities of the banks. There are attempts in preventing the banks from becoming big and teaching them a lesson. There are real regulatory reasons to do some of these but there are also political reasons,” he shared. Recalling the situation that took place in the 1930s where economies fell into trouble and it were the banks that were blamed; numerous attempts were made to bring the institutions down to size. However, those who participated in the exercise were not just the regulators, but the public as well who had been arguing for long that banks are too powerful. The outcome of the push was the formulation of an act that greatly restricted their activities, eventually bringing the banks down to size. As a result of the regulation that was passed in the 1930s, salaries of bankers which were significantly above the salaries of the other sectors of the economy stared moving down. Thus, by limiting their activities in certain ways, they were brought down to size in a way that affected them greatly. Later on in the 1980s as the restrictions put on banks in the 1930 started hurting economic growth, the regulations were relaxed. There were liberalisations in the banking sector and the activities shot up once again. As the money started flowing in, the banking sector was heading towards disaster once again, which questions the type of regulation that should be imposed to keep the sector under control. “The broader point in this is that is that we regulate, we keep them out of trouble, and when we find the regulation too tough we start deregulating. Once we do that we also end up over regulating. The cycle goes on. “The broad question one has to ask is how we ensure that we get the regulation right. How do we get the right amount of regulation without over regulating bad times and under regulating good times?” queried Rajan. He added that while there are a number of regulations imposed on the banks and lot more are yet to come, are the banks going to fall once again two years down the line, especially in emerging markets that requires significant amount of financing for development. Why is does capital regulation help? Capital is typically long term liabilities owned by stakeholders who can accept losses when situations turn bad. In addition to ensuing depositors are protected, the tax payers are also protected from having to pay for the loss of those banks in the future. Capital is usually seen as a loss absorber. It can be equity capital or a long term bond issued by the banks. “There are many roles of the capital regulation. When we say you cannot have risk weighted capital, it means that it cannot take more than a certain amount of risk within budget constraints.” It also gives a push to banks to convince investors that they are more capable of raising more capital than taking more risk. “When long term investors aren’t convinced banks will be constrained from taking more risk. In a way we are asking the market to do the regulation for us,” he said. Furthermore, when the banks are able to increase capital, for the regulators it means the institutions are able to do good. That is they are able to raise money and the market has seen its capabilities and has given the stamp of quality by putting their money in. “What capital helps us regulators is that it prevents individual institutions from going bad. When all the banks are well capitalised, the fear that the system may go insolvent and spread to other institutions does not exist. When the system is healthy there are is limited risk,” added Rajan. It’s all about discipline When there is the formation of ‘too big to fear’ institutions, people will continue to put their money in it since they are certain it is one such that the Government will not let go and will not be subjected to appropriate market discipline. “When market discipline is breaking down, the regulators have a legitimate interest in increasing the rate of capital requirement. Doing so reduces the chances of it eating to the capital is smaller and the system is better protected,” he said. What is the cost of capital? Is there are problem? To this banks would answer yes and justify that if they are asked to put in more capital to run a business, the cost of funding goes up and the borrowers should be charged more. The response from a number of academics is that the risk of any bank is determined by the assets it holds. That is why it is financed. It doesn’t matter how much equity or debt it is financed with, the risk will go on to whatever liabilities are there. The cost of financing is not affected by the issuing of debt. The cost of equity and debt will remain the same. If debt is issued in the market there will be much higher interest rate. The academics are in the view that by holding more equity and increasing capital will ensure that the cost of debt issued will be lower and the banks will be safer. Rajan opined that what the academic miss out is the rational for banks. “If you think about it, banks have been financed with short term liability, the deposits, which makes banks subject to funds. So you have to ask yourself that is there something that gives structure to the banks. At one hand it makes it more fragile and on the other hand it makes it more special,” he said. Rajan emphasised that much of the discipline comes in gaining a short term liability structures. The discipline comes from lenders who at any time might ask for their moneys. “When you have long term liabilities there would no control in what the banker does with the assets. The liability structure affects the kind of structure that you make. If you have long term liability without corporate governance, the investors will have no control. In having short term liability, banks are forced to manage risk properly and have enough liquidity to pay lenders and collect the loans within a specific timeframe. All of these help discipline a bank,” expressed Rajan. Banks need to find an intermediate position There are a number of reasons as to why capital regulation becomes problematic. The collective mortgage backed security got the banks in trouble before the financial crisis. It had the greater risk for the lowest capital. And because of that banks have to be cautious is putting all its faith in capital regulation because it may be offering low risk weight for the wrong type of asset. “One of the worries is that with capital requirement may coordinate with risk weighted assets that may not be appropriate ever time and crate the systemic risk that the regulator is trying to avoid. Assuming that piling capital regulation on banks works, and we do prevent the bank from riskier activities, where do such risks go? If the risks don’t go through the banks it will go through the unregulated part of the financial system. While there is much regulation for the regular financial system, there is a large part of the shadow financial system goes unregulated. The more you push on the regulatory part on the banks, the more will go to the shadow parts of the financial system,” stressed Rajan. For this he opined banks need to have uniform a regulation across the system rather than pushing it from one side and seeing the risk migrate to the other side. Overemphasising regulation is an issue Once of the concerns of capital regulation is that at times it is overemphasised. Over and above governance and incentives regulators need to take the right incentives and action at the right time. If the regulator lags in good times and excessive in bad times, it will lead to problems in the future, said Rajan. “We need resolutions. We have massively complicated institutions and perhaps if we can find ways of resolving them and shrinking them when time comes, that may be better than holding significant amount of capital. There are other reasons why we shouldn’t emphasise capital regulation too much. One possibility of overrating through capital regulation will lead banks to take risks that become systemic. And if we don’t regulate the shadow financial system and over regulate the regular financial system, there will be risk migration into the parts we are not regulation. By focusing on capital regulation we may underemphasise other areas that are equally important, which comes under different lengths of the BASEL system,” he explaine Is the model used in the developed relevant to emerging nations? Questioning if developed and emerging nations have the same kind of banks and financial systems as the industrial countries, he said explored if it is likely that any banks from the emerging regions are likely to take its country down with it. “I am not saying that none of our banks do it and will not do it in the next 10 to 15 years. The question we need to ask ourselves is that are we being led down by the regulatory path that is right for those countries but not for those countries that like ours since the financial needs are different. “I am not asserting this but it is a thought we must explore because in many of these situations we take the agenda laid out by these countries and that is being driven by the thought of the great financial crisis which hit them much more than us. So why is regulation so strenuous? It is because regulators have to show they are worth and as a result have excessive regulation in the down turn,” opined Rajan.