The road ahead for banking regulation

The global financial meltdown has come as a rude shock to regulators. Regulation has clearly failed to keep pace with complexity. Many of the institutions guiding the financial system in the west, especially in the US were fashioned during the Great Depression. In the past seven decades, the financial system has become considerably complicated and interlinked but regulation has not kept pace.
It is clear that multiple regulators in the US aggravated the sub prime meltdown. The Fed, Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) and the National Credit Union Association (NCVA) were all involved in mortgage regulation. As Mark Zandy of Moody's has mentioned, “… with so many diverse groups involved, it was difficult to get a working quorum for decision making. At a time when oversight was most desperately needed on mortgages, half the nation’s lenders were regulated at the federal level and half by the states… Understaffed state regulators lacked resources to monitor a rapidly growing and increasingly sophisticated mortgage industry.” Jamie Dimon CEO, has echoed similar sentiments in JP Morgan’s 2008 annual report, “Overlapping responsibilities have led to a diffusion of responsibility and an unproductive competition among regulators which probably accelerated a race to the bottom.” Many regulators also lacked the appropriate statutory authority to deal with some of the problems they were about to face during the financial meltdown.

Banks must adopt a more long term approach towards capital management. They must build a buffer during the good times that they can draw down during a recession. A key challenge for regulators is to estimate the amount of capital that can act as a reasonable safety buffer to cope with a downturn. The figure of 8% of risk weighted assets is being challenged. Indeed, many global banks have started to maintain capital amounts much larger that this figure. The quantum of capital should change dynamically with the needs of the system. As Bruner and Carr point out,“The question of adequate sufficiency must be tested relative to the size of the available assets and the size of the shocks the buffer is meant to absorb. Over time, the size and complexity of the economy will outgrow the sophistication of static financial safety buffers.”