Market forces drive deleveraging as well as regulation – Caruana

Rolling back post-crisis regulation would not end the problems many banks are struggling with, Jaime Caruana told a conference in London today (November 17).

The Bank for International Settlements' (BIS) general manager noted the marked trend towards deleveraging in the years after the crisis, but stressed much of it came before regulation started to bite.

"These moves to more and better capital are a response not only to regulation, but also to market pressure, as the crisis experience has also sharpened the risk perception of banks, bank creditors and equity market investors," he said.

Caruana showed a graph displaying a precipitous drop in US broker-dealer leverage that came immediately after the Lehman Brothers' collapse, followed by a shallower decrease in subsequent years. This latter movement could have been partly driven by regulation, he admitted.

Markets impose discipline on banks by offering lower funding costs to those with stronger capital positions, Caruana said. Particularly because of the uncertainty around stress test scenarios, banks with only a thin buffer of capital above regulatory minimums tend to be penalised.

Regulation has pushed up banks' costs, as liquidity requirements and loss-absorbency have made funding more expensive. But the BIS general manager argued much of this was intended. Ongoing research into whether market liquidity is impaired has failed to uncover evidence of any serious unintended consequences so far, he said.

A subsequent discussion, held under the Chatham House Rule, saw some participants challenge elements of Caruana's speech. One market practitioner complained markets' views are often dismissed as "anecdotal", adding that many regulations are "disfavouring" business areas such as market-making. Some of this is unintended and "needs to be figured out", he said.

Another participant, an academic, noted there was a tension between efforts to end "too big to fail", particularly through total loss-absorbing capacity (TLAC), and the need to build capital. Issuing TLAC drives up banks' cost of funding, making capital accumulation via cost-cutting more difficult.

The same participant pointed to a "dividend paradox" at banks – chief executives do not want to show signs of weakness by cutting dividends, but doing so could raise capital and thereby lower funding costs. The participant said supervisors could help break this collective action problem by issuing mandatory curbs on dividend payments.

Participants also saw a need to consider the regulatory and macro-prudential landscape as a whole, with one suggesting the post-crisis haste of institutional reform had led to a "piecemeal" approach to regulation.