Over the past six years or so, following the worst depths of the global financial crisis and the Great Recession, one of the prime focuses for the enormous and powerful regulatory authorities in the financial industry has been holding banks and large financial institutions accountable for their behavior. Few observers can deny that the risks taken by nearly all of the biggest players in the banking industry directly contributed to the onset of the crisis; moreover, the lack of accountability meant that the crisis was exacerbated several times throughout the rocky recovery period.
This recovery phase, as most experts will acknowledge, is still not over—even in 2016. There remains a considerable amount of work to be done, from restructuring the financial system to establishing newfound trust and confidence among the public.
Key to this makeover are tougher rules about what kind of risk big banks are permitted to take on. At minimum, the major cogs in the banking industry must stop short of externalizing their risk and leverage onto the general public. This is what happens when risky subprime assets and junk bonds are packaged and sold to average people. It's also what happens when the banking industry resorts to increasingly risky financialization schemes because it believes it is "Too Big To Fail" and will always be bailed out by the safety net of big government. The unthinkable measure of "bailing in" a bank with depositor funds is now actually something these firms are considering doing if they can get away with it.
But what is actually being done to reign in the banking industry? Further, can it be done without cutting the system's legs off completely?
The Basel Accord
Attempts to inject some oversight into the banking industry began with the Basel Committee on Banking Supervision (BCBS), a council made up of members representing 27 of the world's largest economies. The name "Basel" refers to the fact that the committee is headquartered in Basel, Switzerland and has often held its meetings there.
The group was first formed in 1974 and originally had 10 member nations. However, the first Basel Accord (referred to as "Basel I," as several subsequent accords have been reached) was not formalized until 1988. The subsequent Basel II standards (2004) were meant to supersede the previous agreement, but were followed irregularly in the U.S. For this reason, many later blamed Basel II for helping encourage the behaviors that led to the crisis of 2008. While the near-implosion of the global financial and banking system prompted the Basel III standards, these rules are still seen as inadequate to prevent another shock to the banking industry.
Known as "Basel IV," a new set of regulations is expected to take effect by 2019. Among the new measures is an emphasis on using standardized models for an institution's capital needs—how much capital they allocate to cover various risks. Institutional fiduciary services (financial management firms) frequently decide their own capital needs, causing inconsistency across the banking industry. This makes these institutions harder to regulate effectively.
Related to standardized models are more stringent capital controls for banks. This directly stipulates how much capital a bank must have to back up its operations. Higher capital requirements are intended to prevent banks from taking on more risk than they can handle in case something goes wrong. Much has been made about the negative consequences of tightening capital controls on big banks, but these new rules must be implemented with consumer protection in mind.
Another important measure is the Basel committee's insistence that institutions keep their trading books and their banking books separate. By restricting the banking industry in this manner, over-speculation and covering up problems by shifting assets from one "book" to the other are supposed to be mitigated. Overall, it helps maintain the integrity of the firm's financial health by preventing them from fudging the numbers too much to their advantage.
Whether these regulations prove useful or overly constrictive will only be told by time. Yet, for many innocent investors and taxpayers who were ruined by the crisis, the more pertinent time frame may be it's about time.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.