The majority of post-crisis regulation may be in place and working, but now is no time to declare victory in the war on risk, warns the Bank of International Settlements (BIS).
In a new paper on post-crisis international financial regulatory reforms, BIS reviews how successful the regulatory frameworks that followed the 2008 financial crash have been at enhancing banks鈥� and central counterparties鈥� (CCPs) ability to weather market shocks.
鈥淭he post-crisis regulatory reform package has unquestionably increased the shock-absorbing capacity of the financial system,鈥� the paper states. 鈥淏y improving the quantity, quality and robustness of banks鈥� required capital and by formulating integrated and stricter principles for CCPs, it has raised loss-absorbing resources for previously covered risks.鈥�
The report鈥檚 authors go on to say that the consensus within the international regulatory and supervisory community is that the priority now is ensuring the final pieces of the puzzle are slotted into place, adding that stakeholders must not give in to growing calls for rules to be watered down.
鈥淲ith the memory of the Great Financial Crisis fading, and after a long and exhausting deliberating process, the pressures to dilute the agreed standards has naturally grown. This is one reason why we have stressed the importance of maintaining a conservative approach to regulation.鈥�
The paper was published in April but was written before the COVID-19 pandemic hijacked the regulatory calendar and derailed multiple timetables for regulatory implementation, including 鈥� a key focus area for the authors 鈥� which was pushed back by a year.
The extreme market volatility caused by the virus has been an unwanted test of the very frameworks the paper reviewed, including the liquidity coverage ratio (LCR) and net stable funding ratio that came as part of Basel III鈥檚 bundle of liquidity-enhancing reforms.
The declared in a report released last month that repo markets functioned 鈥渞elatively well through the COVID-19 crisis so far, although this is in the face of a number of constraints, not least on banks鈥� capacity to intermediate at a time of heightened demand, and which again highlights the dependence of market functioning on central bank intervention鈥�.
US money markets also muddled through under the circumstances, although this was in large part due to frequent and liberal injections of cash by the throughout the troubled period, which included the first quarter-end of the year.
In both markets questions around how to wean financial institutions off their over-reliance on central banks during periods of volatility remain unanswered, although some form of re-writing of rules like LCR is widely touted as part of the solution.
More seeds to sow
The BIS paper concedes: 鈥淚t would be imprudent to declare victory, even once the agreed implementation of the regulatory package is finalised. The new regulatory apparatus
is not perfect; none can be.鈥�
Addressing this the paper highlights what it describes as 鈥渂arren patches鈥� in the regulatory forest, to denote areas that require further attention.
Chief among these foliage-challenged areas, according to the paper, is the lingering concern that banks and CCPs may overstate their capital strength by not correctly accounting for provisioning and charge-off practices, i.e. bad debts.
Moreover, the paper highlights the differential regulatory treatment of 鈥渇unctionally
similar transactions鈥�, such as foreign exchange (FX) swaps and repos where accounting standards imply that swaps do not appear on balance sheets while repos do.
Owing to such differences in accounting treatment, regulatory standards treat
the two transactions very differently despite their economic equivalence, the paper notes.
鈥淢ost notably, borrowing through swaps rather than through repos vastly reduces the capital requirement in the leverage ratio,鈥� the authors explain. 鈥淭his inconsistent treatment can be a source of regulatory arbitrage, with banks seeking to lower their capital requirements by ramping up FX swap transactions without reducing risk-taking.鈥�
The full report can be read .
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