1 Introduction
This chapter is divided into five sections. Section 2 deals with the rationale for regulation. Section 3 deals with historical developments. Section 4 deals with regulatory responses. Section 5 deals with the specific impact of the global financial crisis upon global and European Union (EU) developments. Section 6 provides some concluding observations.
2 The Rationale for Regulation
Why do we regulate banks? There are essentially three key reasons. Firstly, there is the prudential rationale. Banks are inherently risky due to their role in the maturity and liquidity transformation of short-term liquid liabilities into long-term illiquid assets. Banks accept deposits that are repayable either on demand or within a relatively short timeframe while making loans that have much longer tenors. This is essential if banks are to perform their social function of financing investment in the real economy, including mortgages and other longer-term finance. Banks are by definition prone to bank runs. The very nature of commercial banking is the source of their vulnerability. Trust and confidence are the preconditions of a functioning banking market. The financial crisis and its aftermath constituted a stark reminder that such confidence is fragile. Northern Rock in the UK and Banco Popular in Spain are some of the most recent examples. As Alan Greenspan made clear to the House Committee on Oversight and Government Reform at the height of the financial crisis âThose of us who have looked to the self-interest of lending institutions to protect shareholderâs equity are in a state of shocked disbeliefâ. There are many reasons for this, although many come back to the design of incentives within banking organisations. The low level of equity traditionally held coupled with informational asymmetries between managers and depositors, the prevailing short-termism of banksâ management and availability of limited liability mean that senior managers and directors have incentives to take risks that maximise often personal returns without adequate regard to the losses that a bankâs failure may place on depositors or society at large. Regulation seeks to change incentives through the imposition of mandatory prudential standards. In most cases, it is accompanied by measures to directly protect consumers usually through the provision of information and depositor protection (protective regulation). More recently, a consensus has emerged in many jurisdictions that retail depositors need to be protected through insolvency law and resolution procedures ranking as preferred creditors in a winding up of a bank (Article 108 of Directive 2014/59/EU, the âBRRDâ).
Secondly, regulation may be justified by monetary policy concerns, since central banks issue money and since bank deposits are the largest component of the money supply. Independent central banks with a price stability mandate require some effective control over the money supply. Even if one does not subscribe to Friedmanâs dictum that âinflation is always and everywhere a monetary phenomenonâ, there is a clear historical and empirical connection between rapid rises in the money supply and inflation (Friedman 1963). A second monetary policy objective brought into focus in the Eurozone crisis is the monetary transmission mechanism under which policy rates set by the central bank in the implementation of monetary policy are translated into real lending rates for businesses and consumers. Where the banking system is perceived as fragile or risky, then concerns over bank credit risk will prevent monetary policy decisions being passed on to the real economy with adverse effects for growth and employment.
A third rationale for regulation is addressing systemic risk and arises from the interconnectedness of the financial (including the banking) system. This is the risk that the insolvency or illiquidity of an individual bank could have consequences for the wider financial system as evidenced in the period after the collapse of Lehman Brothers in September 2008 when inter-bank liquidity became frozen necessitating the massive emergency provision of liquidity by central banks. Essentially banks lost confidence in their counterpartiesâ solvency or liquidity. Because of their precrisis dependence on the inter-bank market, banks responded by cutting back lending to the real economy, triggering what has been named the Great Recession of 2008â2009. But the issue of systemic risk goes wider and deeper, demonstrating a more general failing in banking regulation and supervision: the absence of any agreed principles or rules on recovery and resolution, the inadequacy of general insolvency law to address the problems of banks (or systemic investment firms) in financial difficulties and the need for a macro-prudential policy to complement the traditional micro-prudential to supervision. Bank failures impose wider costs on the rest of society, that go beyond their impact on shareholders and other capital providers (externalities). Given the traditional high level of reliance on bank funding in the EU, the problem is particularly acute in Europe. The position is less severe in the US, where capital markets have provided diversified sources of funding. The difference between the availability of equity financing between the two markets (US/EU) has been one of the drivers behind the EU project of capital markets union. Moreover, recessions associated with a banking crisis historically last longer and impose greater economic costs than other recession (Reinhart and Rogoff 2009).
There are other rationales that have been advanced for banking regulation including an alleged public interest in banking, the promotion of efficiency and competition. It should be recognised that regulation is not the only solution to the problems outlined above and other instruments exist to promote a sounder and more resilient banking system including tax policy (the different tax treatment of debt and equity being notorious), laws and principles on corporate governance, disclosure, requirements in respect of market integrity and fiduciary law. However, no jurisdiction has been able to dispense with regulationâand its attendant, supervisionâas the key means to promote a stable banking system. However, as banking regulation has evolved in an essentially responsive fashion, a brief historical review of the developments in banking and regulation is therefore appropriate when considering the balance between national and international standards and the role of soft and hard law.
3 Historical Developments
Historically, a national corpus of specific banking regulation developed first in the US in response to the banking panic of 1907 (in many European countries, banking regulation was embedded within the general administrative taw framework). The Federal Reserve Act 1913 established the Federal Reserve System (the Fed) as the central bank of the US and required all nationally chartered banks to become members of the Fed and introduced reserve requirements inter alia. State-chartered banks were subject to applicable state law. However, the system came under great pressure as a result of the Great Depression. In total more than 10,000 banksâout of nearly 25,000 previously active banksâclosed by 1933, and while the stock market crash was not the proximate cause of banking failures, there was considerable political pressure for reform (Calomiris 2010). The Banking Act 1933âor GlassâSteagall Actâseparated commercial and investment banking activities and introduced federal deposit insurance, with the establishment of the Federal Deposit Insurance Corporation, FDIC (Lastra 1996). Regulation Q limited the paying of interest on bank accounts, while existing state laws placed restrictions on out-of-state branching for state banks. The result was a banking system essentially fragmented on state lines that prevailed until the 1980s. Supervision was divided between the Federal Reserve System, the Office of the Comptroller of the Currency, or OCC (for national banks), the FDIC and state regulators and remained essentially discretionary. It was not until 1983 that US regulators were given powers to issue capital requirements.
In Britain, which did not face any major banking insolvencies during the Great Depression, banking regulation remained non-statutory, informally applied by the Bank of England. In 1946, the Bank of England was nationalised but with very little effect on the informal method of regulation applied by the Bank and the Treasury despite the 1946 Act conferring certain statutory powers. Of course, the degree of control over the economy exercised by post-War governments, periodic capital controls, exchange controls and the Bretton Woods fixed but adjustable exchange rate system acted as inhibitors to innovation and competition in the banking market. This did not mean that banks remained still, and commencing in the later 1950s, UK banks began to diversify, investing in finance subsidiaries to profit from the Eurocurrency market, as well as by amalgamations amongst clearing banks. However, the real trigger to the introduction of statutory prudential supervision by the Bank of England was the Secondary Banking Crisis and the UKâs accession to the European Economic Community (EEC) necessitating implementation of the First Banking Directive of 1977 that resulted in enactment of the Banking Act 1979 which ârepresented the first legal codification of the regulatory and supervisory authority of the Bank of Englandâ (Norton 1995). Initially, the 1979 Act did not change the Bankâs informal, non-legalistic and flexible approach to supervision.
The 1980s were to see fundamental changes to the banking market under the twin pressures of financial innovation and deregulation which reflected the political Zeitgeist of the time. Exchange controls in the UK were abolished in 1979, and the securities markets deregulated through Big Bang in 1986 turning London into a financial centre to rival New York with restrictions on foreign ownership abolished. LIFFE started operations in 1982. A parallel process of deregulation in the 1980s and 1990s took place in the US with the phasing out of restrictions on interest on deposit accounts, the elimination of restrictions on inter-state branching, and the relaxation and eventually repeal of the GlassâSteagall Act restrictions on combining commercial and investment banking. In 2000, Congress decided not to regulate the growing over the counter (OTC) derivatives market. Deregulation of the savings and loans industry proved less successful necessitating a federal bailout in 1989.
However, perhaps the most significant and successful phase of deregulation occurred in the European Union/Community under the aegis of its 1992 initiative. Announced by the Commission in its White Paper on Completing the Internal Market (1985) and endorsed by the Member States through the Single European Act (1987), the aim was to create an internal market for goods and many services (including banking) by 1992. The Single European Act introduced majority voting in the Council for most internal market measures and was based on a paradigm of minimum harmonisation through the use of directives coupled with mutual recognition. The use of directives was characteristic as it preserved the autonomy of each Member state, within the limits set by minimum standards, to make its own regulatory and supervisory choices.
This was translated to the banking sector through the Second Banking Directive (1989) that enshrined the right of a bank, under home-state supervision, to establish a branch anywhere else in the European Community (EC), or to provide services on a cross-border basis. Host states were effectively restricted to enforcing conduct of business rules, rules on market integrity and statistical reporting, in 1994, the Single Marketâincluding bankingâwas extended to the European Free Trade Association (EFTA) states (minus Switzerland) through the European Economic Area (EEA) Agreement and the EU itself expanded through successive enlargements in 1995, 2004, 2007 and 2013 to form the worldâs largest and most integrated market. At the same time, the EU pursued the elimination of exchange controls as well as most impediments to take-overs through a market-based competition policy. However, the greatest contribution to financial integration in Europe prior to the financial crisis was the introduction of the euro as the single currency of now 19 Member States under the Maastricht Treaty (1992). The euro eliminated foreign exchange risk and acted as a considerable stimulus to financial market integration in Europe. At the same time, the adoption of the universal banking model by the Second Banking Directive saw an increasing blurring of the activities of commercial and investment banks.
4 Regulatory Responses
The developments outlined in the preceding paragraphs had their counterpart in the elaboration of a new structure of regulation which moved from the informal to more detailed and rules-based.
This raises a seeming paradox as why should deregulation and innovation require more detailed policymaking. The answer is provided by the factors set out in the first section of this paper: the need for sound prudential controls, monetary policy management and the mitigation of systemic risk. Deregulation without an appropriate legal framework to address the externalities of private risk-taking behaviour risks creating a systemic crisis as was seen in the savings and loans debacle in the US.
The collapse of the Bretton Woods System and first oil price shock triggered significant exchange rate volatility and risk leading in 1974 to the failure of Bankhaus Herstatt and other banks exposing the risks to the global payments system of applying national insolvency laws to banks trading across different markets and time zones (Lastra and Olivares Caminal 2009). The G10 responded by setting up the Committee on Banking Regulations and Supervisory Practices (now the Basel Committee on Banking Supervision) under the auspices of the bank for International Settlements (BIS). The mandate of the Basel Committee has changed overtime and is currently stated according to its website to be âthe primary global standard setter for the prudential regulation of banksâ and âa forum for cooperation on banking supervisory mattersâ. It seeks to do this, inter alia, through âestablishing and promoting globa...