Sunday, June 12, 2016

Should Size Matter When it Comes to Financial Regulation?

Author: David Schwartz J.D. CPA

In a June 8, 2016 address in Berlin, Dr. Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, spoke about potentially easing the burden on smaller financial institutions by calibrating financial regulation based on banking entities' size and complexity. Dr. Dombret began his remarks by warning that the burdens of regulatory reform may be overwhelming smaller institutions. And with only larger banks able to cope, increased regulation may have the unintended effect of driving more consolidation, resulting in less diversity, more concentration of risk, and perpetuation of the too big to fail phenomenon.


According to Dr. Dombret, as rules are becoming more and more complex and interconnected, it is becoming increasingly difficult for smaller institutions with limited human and technological resources to cope. 


“But what exactly is behind the increase in complexity? It is the vase number of rules, the increase in the degree of detail, the expansion of the already-enormous technical specification and the growth in the multiplicity of regulation. This has made compliance with the rules and increasingly costly, time-consuming and unwieldy undertaking.  Such a complicated set of rules is all but bound to lead to a considerable increase in the costs of compliance."


These costs of compliance have to be weighed against the benefits of averting or preventing another financial crisis, however.  But can these regulations be graduated relative to the size of the financial institution without jeopardizing the stability of the financial system?  Dombrat believes they can.  The place to start, he says, is in tackling the issues of operational burdens using two optional approaches.  First, is a details-driven approach that involves introducing special exceptions for individual rules.   Under this approach, Dr. Dombret proposes starting by reevaluating what data institutions are currently required to report, with any excess reporting requirements for smaller entities reduced in a targeted manner.  


Under a second approach, banking regulations could be redrafted from scratch, establishing a new legal basis in the EU and elsewhere for introducing simplifications for smaller institutions in the grand design of the framework. Dr. Dombret posits the creation of separate regulatory regimes in the EU for smaller institutions on one hand, and larger, multi-national institutions on the other.  He points to just such a regime set up in the US for smaller banking entities versus larger ones.  


“A two-tiered system could be put into practice by grading Basel Standards for institutions that are neither multinationals or large in size.  A broadly similar set-up has been up and running in the United States ever since the Basel II regime was implemented.  Any institution that exceeds a balance sheet threshold is subject to Basel rules.


In that scenario, only banking multinationals would be subject to fully loaded Basel III requirements in the EU. That would be appropriate from a risk perspective: global banking institutions would be regulated according to a harmonized set of global rules, while smaller institutions and those operating within a certain region would be governed by graduated rules which do justice to their different business models and risk profiles by setting less complex requirements.” 


Dr. Dombret does warn, however, that simplifications and exemptions for smaller institutions should not become safe harbors for smaller institutions to take on undue risk. 


“Simplifications must never endanger financial stability. Medium-sized, highly systematically interconnected institutions – those referred to as “too interconnected to fail” – and those institutions with risky business models should not benefit from any simplifications. The recent financial crisis, during which many insolvent institutions had to be bailed out, is still fresh in all of our minds.


Additionally, institutions – irrespective of their size – must not be given systematic scope for regulatory arbitrage. In other words, exceptions to the rule must not create incentives for smaller institutions to conduct a greater volume of risky transactions. Proportionality is not intended to make it easier for small institutions to use highly complex procedures and adopt risky business strategies as a result of being shown leniency."


Much progress has been made to curbing risks in the world of banking regulation, particularly amongst the largest players in the industry.  Accordingly, Dr. Dombret believes that it is the right time to address the burdens that this the one-size-fits-all approach is having on smaller institutions.