Bank regulation and supervision a decade after the global financial crisis

It has been more than 10 years since the global financial crisis. As happens after every crisis, this crisis also triggered extensive regulatory reforms, since strong regulation and supervision is essential for the stability and inclusiveness of the banking sector and the crisis revealed many shortcomings. A decade after the crisis is a good time for us to take stock of what reforms have been happening, whether or not they were adopted in developing countries, and what their impact has been. As I have been mentioning for a while now, today we are releasing the Global Financial Development Report 2019/2020, which focuses on these questions. Along with the report, we are also releasing the fifth round of the Bank Regulation and Supervision Survey, which now provides twenty years of data covering 160 countries and hundreds of questions across many aspects of bank regulation and supervision.

What do we see? The database is very comprehensive, but in the report we focus on two of the core areas of bank regulation and supervision: market discipline and capital regulations. Market discipline is a key area we focus on, because providing the right incentives to owners and investors is the first step in ensuring a stable banking system. With good market discipline, participants in the financial sector ensure that banks do not take on excessive risks. However, for market discipline to work effectively, everyone needs to feel that they have their money credibly at risk. In other words, that they will experience losses if they take excessive risks, instead of being bailed out at the expense of the taxpayers. Of course, market participants also need to have good information to be able to monitor how the banks are being run.

One of the more positive developments over the last decade is that many more countries have reformed their resolution schemes, which are intended to reduce the likelihood of bail-outs at taxpayers’ expense. For example, over 1/3rd of developing countries introduced creditor bail-in initiatives and 2/5th have requirements for bank resolution plans. But few put in place a formal regulatory framework to deal with the resolution of international banks, which remains a weak area in general. Unfortunately, these resolution schemes need to be tested by crisis to be credible, and it is not yet clear if these reforms are strong enough to offset the impact of the bailouts during the global financial crisis and the confidence large banks gained in their ability to socialize future losses.

Since the crisis we also see that explicit deposit insurance schemes have been introduced and their coverage and scope were expanded in many countries, particularly in low-income ones. This is a concern since research shows deposit insurance can lead to instability in weak institutional settings. We also see that information disclosure, which would enable better monitoring of banks, has also not improved significantly.

Another important way of improving market discipline is through capital regulation. Among other things, capital regulations make sure that owners of banks have enough “skin in the game” so that they are less likely to take excessive risks. This is also one of the reasons why capital regulation has always been at the heart of bank regulation.

One of the report’s most interesting findings is illustrated in the figure below. We see that developing country banks are in general better capitalized than banks in high-income countries, which have increased their capital only since the crisis.  In fact, regulatory capital ratios—which measure the amount of capital held by banks relative to risk-weighted assets—are at their highest since the global financial crisis.
 

But there’s a big caveat to this finding. Looking at system-wide and bank-level data for over 20,000 banks, we see that this trend has been driven by banks—particularly large banks—shifting their assets into categories that have lower risk weights. That is why the capital-over-total-asset ratios have increased much less.

Why does this matter? Simply put, there’s a big question mark around whether these risk weights genuinely reflect real-world risk. And we saw during the last financial crisis that there was plenty of hidden risk in the system. So while on the surface, it looks like banks may be holding more capital and safer assets than before, the numbers may also be providing a false sense of security.

These are just a few of the findings from Global Financial Development Report 2019/2020. There’s much more in the report, especially on how developing countries and emerging markets can make the right policy trade-offs when designing regulation and supervision for their banking sectors. To learn more, download the report and data at http://www.worldbank.org/financialdevelopment