The end of 'too big to fail'?

Around the world, bank executives are squealing at the proposed toughening of their capital and liquidity requirements and, around the world, regulators are ignoring them and pressing ahead.

Overnight the US Federal Reserve Board published its proposed strengthening of regulation and supervision of big banks and systemically important institutions, triggering immediate warnings that the proposals would shrink lending and capital markets.

Earlier this week, former Commonwealth Bank chief executive Ralph Norris said the Australian Prudential Regulation Authority's proposed accelerated timetable, relative to most of the rest of the world, for implementing the Basel III reforms could lead to higher interest rates and a credit squeeze. Other senior local bankers have said similar things and their sentiments are echoed in all the other major developed banking jurisdictions.

APRA, however, has been unmoved. It puts the security of the system ahead of the extra costs or decreased lending capacity that might flow from the tougher prudential regime and is anxious to reach that more conservative position as quickly as is practicable.

More capital and more and higher liquidity could, of course, not only help improve the access of the Australian banks to funding, but also, by reducing their riskiness relative to their international peers, lower the cost of debt and equity relative to what they might otherwise have been.

The Fed appears to be taking the same approach, although it has yet to release a timetable for the proposed introduction of its new measures.

It will, however, implement the Basel III capital and liquidity requirements, including the simple leverage ratio and the capital surcharges for systemically important institutions and annual stress testing of those institutions, which will largely be US bank holding companies with assets of $US50 billion or more.

The Fed also came up with a novel idea that will generate considerable new angst among the bigger US banks.

One of the insights into the 'too big to fail' institutions that emerged from the first phase of the financial crisis was how inter-connected the relatively small number of institutions that dominate global financial flows are. That created the spectre of a domino effect if one those institutions were allowed to fail.

A major plank in the wave of new regulation heading towards the banks is not just a strengthening of their financial strength to reduce the risk of failure but to make it possible for regulators to allow banks to fail without spreading contagion through both national and global banking systems. The regulators want to end the moral hazard – and the taxpayer exposure – that the 'too big to fail' banks have created.

The Fed has proposed a limit of 10 per cent of regulatory capital of the exposure of any of its systemically important banks to another. There were immediate cries that this would shrink capital markets, securities lending and inter-bank lending.

While that might affect the size and liquidity of some markets, and the cost of executing transactions, the Fed appears to have adopted the same attitude as APRA – the benefits to the broader community of a safer financial system outweigh the costs to the banks and their shareholders and the flow-on effects in the pricing and availability of credit to the community.

With the prospect of another full-scale global crisis made very real by the eurozone sovereign debt crisis and the allied European bank capital shortfalls, the regulators have a daily reminder of how unstable the global banking sector remains and how difficult and uncertain the path towards a more stable system might quickly become. For the moment, however, they remain committed.