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New Rules Will Curb Risks in U.S. and European Banks

The Bank for International Settlements in Basel, Switzerland: new rules will help reduce risk in the financial system (photo: Newscom)

GLOBAL BANKING RULES

New Rules Will Curb Risks in U.S. and European Banks

IMF Survey online

November 3, 2010

  • Basel III banking rules will help curtail risk at largest investment banks
  • Banks have time to comply with new rules if earnings keep pace
  • Global coordination, effective supervision key to reducing risk

New international banking rules designed to make the global financial system safer will rein in riskier investment banking activities in the United States and Europe, according to a study from the International Monetary Fund.

The rules, commonly known as Basel III, will require banks to hold more and better quality capital and liquid assets to protect against the excessive risk-taking that led to the biggest financial meltdown in 80 years.

Banks will have to retain more of their profits, raise additional capital or reduce their exposure to riskier assets to meet the additional capital and liquidity requirements.

The IMF Staff Position Note, Impact of Regulatory Reforms on Large and Complex Financial Institutions says that a few banks with a global reach handle the vast majority of cross-border finance, and their actions affect financial centers across the world. In the years before the global economic crisis, the build-up of financial risks in these institutions often went unnoticed and unchecked by the regulators and supervisors in charge of overseeing the banks’ activities.

Under the proposals still under discussion by the Group of Twenty leaders of advanced and emerging economies, national regulators may also impose extra charges on systemically important banks. The goal is to prevent institutions from becoming too important, or too complex, to fail and to avoid bailing out these institutions at taxpayers’ expense.

The IMF said requiring banks to hold more capital and liquidity will create a stronger banking system. The stricter Basel III rules will affect banks’ profitability and trigger adjustments in banks’ balance sheets and business strategies, such as shrinking and reposition assets away from the most capital intensive activities, and passing the cost to customers. This could lead to higher risk activities moving out of the banks and into less-regulated parts of the financial system, or to jurisdictions with less stringent regulations.

Regulate locally, cooperate globally

The IMF study said the Basel III rules give banks adequate time to adjust to the new requirements to hold more capital and liquid assets. This assumes global economic growth and bank earnings will expand modestly, as projected. Many banks have begun to raise the additional capital called for under the rules.

All types of banks, such as commercial banks that make their money from lending, investment banks, and universal banks that lend but also deal in insurance and other activities will be affected by the new rules.

The IMF staff said banks that engage in investment banking activities will feel a stronger impact from the rules as regulators introduce tougher capital requirements on bank trading books at the end of 2011.

Investment banking activities will also be affected by a number of other regulatory initiatives, including new accounting rules, higher standards for securitization, trading, and derivatives businesses. Measures to control certain activities such as restrictions on banks trading with their own funds, rather than their clients’, known as proprietary trading will also be part of new regulations.

The IMF also warned that without careful global coordination among national regulators, and effective oversight of the rules, some activities may be shifted out of banks to less regulated sectors or countries, to minimize supervision and regulatory costs.

The key to reducing risk in the global financial system will be continued consistent implementation of the rules through global cooperation by officials with oversight at the national level, according to the IMF.

The IMF staff said that agreement on cross-border resolution of failed banks should be a top priority. The complexity of reaching agreement on effective frameworks for resolving cross-border institutions requires political commitment at the highest level to make progress.


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