image: EuroCrisisExplained.co.uk (flickr)

Punchy title, eh? But when there’s something nobody talks about, but everyone agrees when I mention it, it scares me. So here it is.

In the aftermath of the financial crisis, we don’t just see new regulation emerging. What we see is a homogeneous regulatory framework emerging. The arguments for regulating all firms globally on more or less the same standard are well known:

1. To create a ‘level playing field’
2. To put the power of regulation at a place where the wallet for bailouts is
3. To allow more flexibility to quickly move regulatory resources where the problems are. Cyprus and Iceland weren’t just short of financial resources, but also human resources, when it came to the crunch.
4. To be able to act fast. Colleges of local regulators have less direct communication lines, less coherent approaches, and less ability at the periphery to deal with complex instruments, models and practices than a consolidated regulatory framework can provide.

All fair enough. Except the first, which really worries me. Ever since the Basel accords started, regulators wanted to have one standard for calculating capital reserves for banks, applied equally everywhere. The successful establishment of the EBA has just made this a hard fact in Europe.

Allow me a quick detour, to remind ourselves what capital requirements are for. Minimum capital requirements are there to ensure that banks have the financial discipline and resources to not abuse their two enormous privileges: (a) to have a degree of financial leverage like no other sector, and (b) to have access to central banks as lenders of last resort. It’s the combination of these two privileges that can be dangerous: Leverage creates real risks, but because the central bank’s lending facilities buffer these, there is the temptation to take too much risk in the absence of clear limits.

The way it works is that the regulator puts a risk-weighting on each type of banking activity. This sets a limit how often you can lend a dollar, take one in as a deposit, lend it again, take another as a deposit, lend it again, etc.; If, as a bank, I am allowed to lend $15 against deposits of $14, with only one dollar as my own capital, I am said to have a leverage ratio of 15. And the amount of leverage I am allowed to have depends on the regulator’s risk-weighting applied to that activity. That’s how it should be: On the same capital base, a bank giving unsecured consumer loans is allowed less total loan volume than a bank giving mortgages.

And here is my point that no-body talks about and everyone agrees on: The problem of globally homogeneous capital requirements is that they may increase risk in the system! Here is how that works: Banks in one country may have concentrated exposure to one sector of the economy. Banks in another country to another. Think Brazil and farming, Spain and property, or Germany and Mittelstand. In the interest of diversification — and therefore stability — in the local banking system, regulators should increase the requirements for increased lending in the dominant sector, and decrease it in sectors which may act as risk-diversifiers.

Where regulations are moving to, however, is that local regulators have the freedom to take the first step (punish concentrated lending), but not to do the second (encourage diversified lending). They can wield the stick, but not the carrot. They don’t have the freedom to selectively lower capital requirements for certain activities below the global standard. The regulator is free to slow down the banks and the dominant sector of the economy, but isn’t allowed to accelerate other business whose increased prevalence might actually be beneficial to banking risks and therefore to the banking system’s resilience. Few regulators and/or politicians will be tempted to use the brakes in this scenario, for they are brakes on the overall economy. The local regulators have the freedom to move away from the ‘level playing field’ in one direction only: towards less competitiveness. Before the EBA, regulators could accelerate some lending activities while slowing down others, now they can’t have such a balanced approach. This reduces their overall incentive to act against bubbles. Bubbles will more likely than before.

The other thing we can see when entire sectors of lending are treated the same way around the globe is that some sectors are pushed out of the regulated sphere entirely and everywhere. This is because regulators as a collective are now indirectly setting the relative price for all types of lending: If every bank in the world needs double the capital for asset-backed trade finance than it does for mortgages, it will only engage in asset-backed finance if the margins are double too. And if they are more than double, it has an incentive to switch out of mortgages into that sector. And that’s true for all banks at once. It’s that simple. But since the regulators’ relative price is not market-driven, it does not adapt dynamically to changing economic environments. This means the price is almost always wrong and does not reflect the (changing) relative riskiness of the different banking activities. The result is similar to what happens in a centrally planned economy: some things just don’t get done any more, and a very profitable gray economy springs up to fill the gap. We actually see this happen in pockets already. If the centrally planned economy didn’t plan for enough tires, selling tires in the gray economy becomes much more profitable than it otherwise would be. You need the tires to keep the vehicles running, and you’ll pay almost any price to secure one. Whether that’s a risk or an opportunity depends on where you stand in the debate, but if you are a regulator, the answer is clear. Things don’t get priced by riskiness alone: To  a very substantial extent they get priced by capital requirements.

Also, if sectors are pushed out of the regulated sphere then, the remaining sectors will be less profitable. Perhaps you think it’s o.k. for banks to be less profitable. Fair enough, but that too comes at the price of increased systemic risk, since profit margins are also an element of a bank’s stability.

Admittedly, much of what I said here may by exaggerated for the sake of argument. The solutions to the problem are actually simple (regulate on an overall risk basis and not on a product-by-product basis), and they are also in place for the larger banks. But the following facts remain: The trends described are there to a degree, no-one’s talking about it, and yet everyone agrees. Isn’t that exactly how we ran into the last problem?