There is broad consensus that the post-crisis prudential regulatory reforms have significantly enhanced the resilience of banks globally and contributed to safeguarding financial stability. However, 17 years after the onset of the Great Financial Crisis (GFC) and a decade after the implementation of the initial Basel III standards in many jurisdictions, it is worth reflecting on how the new framework has performed and considering possible adjustments to address its shortcomings and unintended consequences.
Ongoing discussions on this matter reveal a regulatory debate shaped by opposing forces, each advocating for different directions in regulatory stringency.
On one side, recent events, such as the 2023 banking turmoil, suggest that prudential reforms may have fallen short in adequately controlling the risks that led to the collapse of several regional banks in the US and Credit Suisse in Switzerland. Additionally, the turmoil exposed certain deficiencies in the new bank resolution framework developed alongside Basel III after the GFC. These events, coupled with emerging risks such as those related to technological disruption, could justify enhancing the regulatory framework with complementary measures to better prevent and manage financial crises.
On the other side, factors such as subpar economic growth, low bank returns, depressed market valuations in some jurisdictions, and the dynamism of certain non-bank financial institutions have led both private and public sector observers to argue that the regulatory reforms may have gone too far. Some contend that these reforms are not only affecting banks' performance but also their ability to provide funding to the real economy. This perspective underpins calls to reduce the compliance burden on banks. In some cases, these calls advocate for simplifying existing rules, while in others, they explicitly seek to alleviate or eliminate what are perceived as excessively stringent constraints and obligations
As a result, the debate is at a crossroads, with conflicting positions reflecting different interpretations of evidence and, more importantly, varying priorities and constraints that should guide regulation. Finding a compromise between these fundamentally divergent views is no straightforward task. However, as this article will argue, strengthening the supervisory process under Pillar 2 of the Basel Framework could improve the identification and mitigation of banks' risks while keeping regulatory burdens within reasonable limits.
The available evidence on the impact of post-GFC regulatory reforms does not strongly support the view that these reforms have significantly hindered economic dynamism or materially impaired banks' performance. Empirical studies indicate that, even without considering the reforms' ability to reduce the probability and severity of financial crises, tighter prudential standards have had a moderate negative impact on growth. When the medium term benefits of financial stability are factored in, the evidence overwhelmingly points to a significant positive impact.2
Moreover, recent data on banks' performance also indicate that, in some major jurisdictions — like the US — banks have already recovered, or are close to recovering, the profitability and market valuations seen before the GFC, despite the implementation of stricter regulation (Graphs 1 and 2). Poorer performance of banks in other jurisdictions, like the EU, cannot therefore be attributed to the global regulatory reform.
Robust supervisory frameworks may reduce the need for frequent adjustments to regulatory requirements.
Of course, this evidence should be interpreted with caution. At best, it suggests that the overall stringency of Basel standards is not excessive and does not unduly constrain the banking sector's ability to provide credit to the real economy. However, it does not answer whether the same outcomes could be achieved through a more efficient policy framework that imposes fewer short-term costs on the industry.
Conceptually, there is a limit to how stringent regulation can be without jeopardising the sustainability of banks' business models. Banks rely on income generated from the risk, maturity, and liquidity transformation inherent in their activities. If prudential regulation excessively constrains this transformation, it may prevent them from delivering adequate returns to stakeholders, thereby making that business unviable.
At the same time, targeted supervisory actions to address specific weaknesses in regulated banks — before they escalate into crises — can effectively safeguard the safety and soundness of individual financial institutions. Robust supervisory frameworks may reduce the need for frequent adjustments to regulatory requirements across the board, especially for vulnerabilities that are not uniformly relevant to all institutions. By striking the right balance between regulation and supervision, the prudential framework can achieve financial stability goals while minimising compliance costs for the sector.
No feasible amount of capital or liquidity can compensate for risks arising from poor governance.
A pertinent example is the regulatory controls for liquidity risk. The 2023 banking turmoil demonstrated that existing liquidity risk requirements — such as those based on the Liquidity Coverage Ratio (LCR) — are unable to handle deposit runs as intense as those experienced during the episode. While stricter LCR calibrations would theoretically allow banks to better withstand liquidity stress, such measures risk imposing excessively restrictive constraints on liquidity transformation, which may limit banks’ ability to engage in meaningful commercial activities. In other words, overly stringent regulatory actions could minimise the risk of bank runs but at the cost of undermining banks' business viability.3
At the same time, the 2023 banking turmoil also illustrated that liquidity stress episodes often stem from structural vulnerabilities in banks, such as weaknesses in governance, business models, and internal controls. Identifying and addressing these vulnerabilities should be a primary objective of regular supervisory reviews and evaluations.
For supervision to effectively complement regulation, the deployment of well-defined qualitative measures is essential. Supervision cannot rely solely on adjusting quantitative capital or liquidity requirements to banks’ specific circumstances. No feasible amount of capital or liquidity can compensate for risks arising from poor governance or unsustainable business models. By contrast, early supervisory dialogue and moral suasion can often resolve directly issues identified during supervisory reviews. When necessary, supervisors can escalate matters by imposing binding actions proportional to the severity of the identified deficiencies.
The effectiveness of qualitative supervisory measures crucially depends on adequate resources, legal powers, operational independence (of the supervisory authority), and a supervisory culture that encourages early intervention when needed. Meeting, in particular, this latter requirement is challenging as it requires supervisory agencies to adopt a risk tolerance framework that accepts a non-zero level of policy mistakes and successful litigation against supervisory actions.
The effectiveness of qualitative measures hinges on the supervisory frameworks employed by prudential authorities.
In addition, the effectiveness of qualitative measures also hinges on the supervisory frameworks employed by prudential authorities. For instance, an external assessment commissioned by the ECB in 20234 highlighted room for improvement in the formulation, prioritisation, scalability, and monitoring of qualitative supervisory measures within the European banking union. Similar observations could likely apply to supervisory frameworks in other jurisdictions.
A recent FSI paper reviews supervisory practices in major jurisdictions and offers insights for timely and effective deployment of qualitative measures within robust supervisory frameworks. The paper suggests that authorities could benefit from defining their own risk appetite frameworks, which would involve clearly articulating the level of risk they are willing to accept when making risk-based decisions. Combining top-down and bottom up approaches in risk scoping can enhance this process.5
Supervisory ratings play a critical role in identifying banks' qualitative weaknesses and signalling the need for corrective action. A "weakest link" approach, where poor ratings in any component drive the overall rating, ensures that significant weaknesses are not overshadowed by stronger scores in other areas. Elevating the importance of governance ratings and introducing a standalone rating for business model viability — currently absent in some major jurisdictions — can also contribute to making supervision more effective.
Selecting the right tools to address governance and business model assessments is crucial for detecting qualitative weaknesses before they manifest in financial metrics. Establishing a comprehensive set of red flags to inform supervisory action is helpful. More challenging is determining the appropriate supervisory measures for addressing these weaknesses and ensuring their timely implementation. Linking ratings not only to a bank's risk profile but also to management's ability to meet supervisory expectations can incentivise effective corrective measures. Assigning specific responsibilities for required corrections to individual executives or board members or to specific internal committees further enhances accountability.
Judgment is optimised when informed by indicators that support supervisory decisions.
Supervisory frameworks must include clear procedures for communication, monitoring, and escalation. Prioritising key actions for firms is essential, as an exhaustive list of findings from various supervisory reviews can dilute focus and inflate compliance costs. Authorities could issue consolidated letters at the end of supervisory cycles, prioritising key concerns and outlining remediation steps with clear timelines. Robust IT systems are crucial for monitoring corrective actions, while structured escalation procedures ensure consistency in decision-making when banks fail to address identified deficiencies.
More broadly, any effective supervisory framework must allow room for judgment. However, this judgment is optimised when informed by supervisory guidance, criteria, and indicators that support supervisory decisions without introducing rigid playbooks.
The stringency of banking regulation has steadily increased over the past two centuries, driven by the growing complexity of banks' business models and the heightened potential for systemic crises. The regulatory reforms following the GFC have significantly enhanced the official sector’s ability to manage financial stability risks. However, these reforms have not been matched by comparable efforts to establish more effective supervisory frameworks.6
While recent evidence points to the need to enhance the safety and soundness of financial institutions, the option to do so by significantly further tightening regulation should be approached cautiously. After the far-reaching post-crisis reforms, the marginal benefits of additional regulation may have diminished, while the marginal costs of higher regulatory burdens have arguably increased.
Conversely, the case to enhance supervisory frameworks looks quite strong and should therefore become a key priority. Efforts should focus on identifying banks' vulnerabilities and addressing them through well defined, prioritised, and monitored qualitative measures. If successful, these efforts could also support ongoing initiatives to simplify the regulatory framework by streamlining minimum requirements without compromising financial stability objectives.
Fernando Restoy became Chair of the Financial Stability Institute on 1 January 2017. He had been Deputy Governor of the Bank of Spain since 2012. Previously, he held other senior positions at the Bank of Spain, which he joined in 1991. From 1995 to 1997, he was Economic Advisor and Head of the Monetary Framework Section at the European Monetary Institute in Frankfurt. He was Vice Chair of the Spanish Securities and Markets Commission (CNMV) from 2008 to 2012 and Vice Chair of the IOSCO Technical Committee (now Board). He was the Chairman of the Spanish Executive Resolution Authority (FROB) from 2012 to 2015 and was a Member of the Supervisory Board of the ECB's Single Supervisory Mechanism from 2014 to end 2016.
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