Three criticisms of prudential banking regulations

The new prudential regulations known as Basel III, introduced in the aftermath of the financial crisis, place four (actually five, in practice) new constraints on banks. These are a solvency ratio, three liquidity constraints and a leverage ratio. The purpose of this regulatory straitjacket is to enhance the financial soundness of banks, prevent a reoccurrence of the contagion seen in 2008 and reduce systemic risk. Unfortunately, these arrangements have some undesirable consequences and shortcomings. This article highlights three of the problems. The first is that the growing number of constraints, and the parameters applied, will drive up borrowing costs and shrink the supply of credit, even after the period of adaptation and transition is over. Financing market activity could become difficult as the regulations themselves provide an incentive for disintermediation. The second criticism focuses on increased collateral requirements in a world where real mistrust now exists between participants in the financial system. In addition to the collateral requirements for certain transactions, we wish to draw attention to the “hidden” collateral constraint, which requires adequate unencumbered assets to properly cover “unsecured” borrowing. This constraint is no longer merely theoretical; it will affect the banking system’s viability in the medium term. Finally, we show how, in an economy that is risk-free at the macroeconomic level, the fact that banks are interconnected may generate contagion risk and self fulfilling prophecies. This situation is less likely to occur in the case of a creditor outside the system. However, each bank’s risk of failure will depend on the structure of cross-financing and the correlation with risks incurred by other banks. No matter how many constraints are imposed, it is unrealistic to think that regulations applying to banks on an individual basis will be able to ward off systemic risk.