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BLOG. 5 min read

The Sometimes Unintended Consequences of Banking Regulation

As regulators consider their response to the recent banking turmoil triggered by the collapses of Silicon Valley Bank (SVB) and Signature Bank, they would be wise to consider the full impact of their actions.

Regulations are put in place to create stability and instill confidence in the financial system with the goal of preventing financial crises. Although high-minded in intent, regulatory metrics are often implemented in a blunt manner or with a lens focused too narrowly on the causes of the previous crisis. As a result, regulations can sometimes lead to unintended consequences that, in certain cases, can contribute to the causes of future crises.

Case in point: Did the manner in which the liquidity standards, were implemented following the Global Financial Crisis (GFC), indirectly lead to many of the problems faced by banks? In the absence of a strong balance sheet risk management culture, quite possibly. Post-GFC regulations introduced two new liquidity ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). In particular, the LCR sought to ensure banks held enough High-Quality Liquid Assets (HQLAs) to cover 30 days of outflows resulting from a funding and market shock.

Over the last decade, banks increased their HQLAs over the 100% requirement (the EBA reported the EU LCR at 166% as of June 2022). While this may be considered sensible for any individual bank, it results in concentration risk as the banks together hold large quantities of safe assets, such as government bonds, or slightly riskier MBS. These assets may be safe from a counterparty risk perspective, but this does not mean they are risk-free from an interest rate perspective unless they are never sold.

Curiously, the regulation allows for HQLA to include Held to Maturity (HTM) assets, where the intent is to hold the assets until they mature, along with Available for Sale (AFS) assets which are seemingly more consistent with the intent of the HQLA. Furthermore, from an accounting perspective, HTM assets are held at book value with Mark-to-Market (MtM) changes, significantly, not hitting the bank’s balance sheet or income statement directly.

In parallel to this, recent COVID-19 stimulus measures have led to a global savings glut. Banks have had more deposits than ever to place, outpacing loan growth in an environment where, only a year ago, central bank deposits could result in negative yields. It should come as no surprise, then, that an unintended consequence of allowing HTM to be included as part of HQLA, combined with this excess funding, has encouraged banks to focus on higher-yielding liquid assets, exposing them to greater interest rate risk.

Without a strong risk culture, banks are incented to focus more on managing Net Interest Income (NII) and to “ride the yield curve” rather than managing the Economic Value of Equity (EVE) and buffering for interest rate shocks. Unrealized HTM losses have been reported to be sizable as rates increased sharply, and this forms at least one of the structural banking risks in the current crisis. For Silicon Valley Bank, these losses exceeded the entire capital base—a liquidity event crystallized these.

This is not the first time there have been ‘unintended consequences” stemming from the implementation of banking regulations.

The initial Basel I accord was designed to focus on a bank’s capital adequacy, driven by the belief that worldwide capital had eroded during the 1980s with increasing numbers of bank failures. As Basel I regulatory capital was calculated based on accounting measures, an unintended consequence of that regulation was the dramatic increase in so-called “regulatory arbitrage” as banks found ways to reduce their capital requirement despite increasing the risk of their business activities.

The philosophy behind the development of the ensuing Market Risk Amendment (MRA) and Basel II, therefore, was to align regulatory capital requirements more closely with true underlying risks by enabling banks to expand their usage of “internal capital models”—a convergence of regulatory capital and economic capital.

The GFC, which started initially as a credit and market risk crisis due mainly to the unintended consequence of “internal models” vastly underestimating the true risks of complicated credit derivative products, quickly manifested into a full-blown liquidity crisis as depositors globally lost confidence in the valuation of banking sector assets. Subsequently, Basel III was born out of the belief that it had been a mistake to focus so narrowly on capital adequacy in the first place, let alone enabling the expanded use of internal models, as was the philosophy underpinning the MRA and Basel II. Therefore, the intent of Basel III was to not only increase capital requirements but to broaden its focus to include requirements around liquidity risk. This focus on liquidity risk may have partly contributed to SVB’s collapse.

Despite the history, it would be a big mistake to focus entirely on regulations. Even by avoiding unintended consequences, regulation can only ever be part of the story; the solution has to be much more about banks embracing a strong balance sheet risk management culture.

“Regardless of where regulations end up, managing your business well is more important. SS&C solutions help organizations manage their business to reduce risk, increase efficiency and drive better returns.”

William C. Stone
Chief Executive Officer, SS&C Technologies

For more of our analysis of SVB’s collapse, read our "Sobering Lessons from SVB: Manage Financial Risk Beyond Compliance" blog. To learn how SS&C can help you manage risk, contact us.

Steven Good, Senior Manager, Development, also contributed to this article.

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