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Home > Blogs > Anthony Harrington > Irish Central Banker ponders EU regulatory flaws

Irish Central Banker ponders EU regulatory flaws

Irish Central Banker ponders EU regulatory flaws Anthony Harrington

On 26 March 2012, addressing an audience of central bankers at the 4th CDU/CSU Congress at the Bundestag, Berlin, Matthew Elderfield, deputy governor of the Central Bank of Ireland and the Alternate Chairman of the European Banking Authority (EBA) highlighted some of the ironies and flaws of current regulatory efforts.

The gist of his thoughts is actually rather easy to summarise and well worth pondering. Every holder of a political office across Europe, from the most junior politician to Prime Ministers and Presidents, has by now grasped the fact that it would be a jolly good thing if Europe’s banks were capitalized to a considerably greater degree than they are at present. Hence there is huge political pressure for Europe’s regulatory and banking mechanisms to crank up their demands for larger and larger capital buffers. The future of the EU is in play while the banks are wobbly and this has to be fixed. However, as is usual with political enthusiasms, the law of unintended consequences is having a field day.

Put simply, pressuring banks to hold more capital results in them raising some additional capital, but more to the point, it generates in banks a desire to trim whatever parts of their portfolio carry the greatest demands by way of additional capital reserves. In short, they lend less to non-investment grade companies. Hence all this political pressure for regulators to demand higher and higher capital reserves from banks is massively pro-cyclical. Growth in the EU is hovering somewhere between being flat and contracting. Bank lending to the engines of growth, the vast armada of smaller companies, is essential if growth is going to return. But regulatory pressures make such lending highly unattractive to banks. To sum up, instead of raising capital buffers, Elderfield argues, now is probably a pretty good moment for counter cyclical action:

“Procyclicality is the phenomenon by which banking capital rules exacerbate the business cycle by encouraging lending at a time of growth or contracting it in a time of recession. Basel 3 aims to build up a countercyclical buffer to lean against the wind in good times and be eased to help growth in bad times. We are evidently in bad times now, so intriguingly this has prompted some to consider whether you should in fact be starting to release the buffer…”

In other words, all this pressure for banks to hold more capital in reserve could not be coming at a worse time. “Indeed, you could probably run the Basel countercyclical buffer methodology with some plausible assumptions and get to the conclusion that for many countries we are well  past the point where the buffer would be released,” he told his audience. Of course, Basel 3 is not yet in full swing so there isn’t that much, if anything, by way of capital buffers to release and the whole idea is moot. But it makes the point. When it comes to bank capital reserves, less, not more, is where we should be headed, right now. Moreover, this switch of direction is being dictated at a formal, theoretical level by Basel 3 itself. Yet all the political pressure is going in the exact opposite direction. In the eyes of politicians and the public alike, banks are a threat and should be pushed firmly in the direction of making themselves more resilient by hoarding capital. What Elderfield would like to see is what he calls "a breathing space in terms of further initiatives on the capital front."

"The central dilemma is that for microprudential regulators more capital is a good thing - but that from a macroprudential perspective there is a concern about how fast to get that, and at what cost."

He points out that recent banking stress tests have exacerbated the problem:

"(They) have evolved into what might be described as a "capital shortfall" calculation: setting a single scenario and a specially created threshold to effectively prescribe additional capital even where not required by EU law or Basel rules... I fear that trying to satisfy insatiable market expectations of conservatism in a stress test risks being very procyclical."

Add to this the fact that the market is also pressuring the banks via their share price to move much more rapidly than the deadlines in Basel 3 to achieve the required capital reserves and what we end up with is a massive lending crunch. Elderfield knows that he is shouting into the wind in calling for a breathing space, but it is encouraging to see that central bankers themselves are alive to the negative impact all the demands for banks to hold more capital is likely to have on Europe's fragile economy through 2012 and beyond. They haven't figured out what to do about it. That "breathing space" hasn't got a snowball's chance of becoming a reality unless the politicians start listening, which is highly unlikely. But at least they are thinking...

Further reading on regulation:

Tags: Basel III , capital buffers , capital raising , capital reserves , Central Bank of Ireland , central bankers , EBA , EU , European bank funding , European Banking Authority , European Central Bank , European markets , Ireland , Irish economy , procyclicality , Prudential Regulatory Authority , regulation
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