A View From INSEAD

Bank Regulations

Professor Jean Dermine

Programme Director of the Strategic Management in Banking and Risk Management in Banking programmes
September 2012

Since the 2008 crisis, everyone has been talking about banking regulations. And despite the 2011 international agreement, known as 'Basel III', the talking continues – not least at INSEAD, which as a leading international business school, carries out both teaching and research in the field of banking. One of our greatest experts is Professor Jean Dermine, who advises both commercial and central banks. Here he gives his views on bank regulations…

What are the new banking regulations?

To simplify, there are three types of regulations. One is regulation of capital – increasing the equity level of banks. Two is very strong regulation of liquidity – making sure that if money flows out of the banks, banks will have liquid assets to meet cash outflow. And three is about corporate structure, in particular whether investment banking activity should be totally separate from regular banking activity.

How do the bank regulations differ across countries?

Taking corporate structure as an example, the US is taking a strong view about pushing some activities like hedge funds, private equity, proprietary trading totally out of the banks, while in Great Britain, they still see a synergy between retail banking and investment banking: a banking group would be allowed to conduct both activities but in separate subsidiaries.

So the investment bank could fail, but the retail bank would continue?

Right. However, personally I am not at all convinced, because what happened in countries like Iceland, Ireland and Spain had nothing to do with investment banking. It was pure regular banking: too much lending on the real estate and mortgage markets. Even in Britain, the first bank that got into trouble, Northern Rock, had nothing to do with investment banking. I’m not at all sure that British authorities would dare to let a large investment bank default.

Everybody has been calling for more regulations, so why do you sound so sceptical?

I believe we are currently addressing just a symptom – and with a massive over-reaction of bank regulators. We are going to force a massive increase of bank capital. And we are going to force banks to hold liquid assets. But we should not forget that banks are extraordinarily useful in the real economy: to finance lending to small and medium-sized companies. If you have too stringent regulations, the cost of lending is going to go up massively and the cost of loans to small firms will increase. Or, more likely, banks are going to push certain activities outside the bank and use all kinds of vehicles that are not regulated. That’s really where the crisis started.

So what would be the right kind of bank regulation?

I’m very convinced, as are many economists, that the root of the problem is that very large banks know they are 'too big to fail'. Because of that, they take too much risk. So the issue that we must address – and that has not been addressed for years – is how can we put large banks into default? The bankruptcy laws in our countries are not really able to handle bank default. The problem is that you cannot simply close a bank, like another company, and say: 'Please come back in six months’ time when we reopen.' You would kill the economy!

And the solution to this is…?

Some countries are starting on what they call 'resolution regime', which means that, before the bank is bankrupt, there is a system to recapitalize it and turn creditors’ debt into equity. In my opinion, it is not only bond holders who should be put at risk but all creditors, except maybe the small depositors. Why? Because all the banks are lending to one another. They know very well what other banks are doing and are much better informed than most bond holders. If all creditors, in particular the banks, are put at risk they will be much more prudent.

How would you sum up the current situation in banking regulation?

Well first, there is tremendous legal complexity today, since banks are international, operate across borders, in particular with subsidiaries. So there’s a massive legal problem. How do we harmonize resolution regime around the world? I kind of regret that three or four years after the crisis, we are moving so slowly into that direction. Second, it is very, very clear that there is very strong opposition from the banking community. The banks do not want their inter-bank transactions to be put at risk. They want to put all the risk on the bond holders, for obvious reasons. As long as we are not attacking this problem, we can expect to have another crisis in the future.

To learn more from Jean Dermine, click here and watch the video interview on which the above article is based. Alternatively, consider enrolling on one of the two Executive Education programmes he directs for senior managers in banking Strategic Management in Banking and Risk Management in Banking.

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