Laura Gatz: A warm welcome to an all new episode of ‘economics in business.’
Ten years ago the financial crisis hit. In its aftermath much has changed in global markets. In particular, the crisis resulted in a considerable package of reforms in the banking sector, and has fundamentally changed the way that the sector is regulated.
I am Laura Gatz, and I am joined here today by Nick Forrest, who heads our financial economics team.
Nick, you’ve been working with AFME, The Association for Financial Markets in Europe to investigate the effects that the new regulatory system has had on banks.
Let’s start from the beginning, what actually was the goal of introducing these reforms in the first place?
Nick Forrest: Thanks Laura.
Essentially the goal of the banking reforms was to prevent another financial crisis - that was very damaging to the economy, to businesses, even to individuals. The policymakers’ response was to make sure that never happened again. The challenge was that there are so many reasons for the financial crisis. There is no single one reason or cause, and that meant that actually the regulatory response had to be a big package of measures to meet that goal.
Laura: What actually does the regulation do to address all these issues?
Nick: The regulation, as I said, tries to hit a number of challenges that the financial crisis revealed. A big area of regulation has been around capital, making sure that banks have got more capital or reserves to absorb losses.
When a loan becomes impaired or banks lose money, it has got more buffers there to be able to sustain those losses. So, the reforms have required banks to have more and more capital in relation to their assets. Some assets of banks are quite different. Some are low risk, like a residential mortgage; some may be far more risky, like a trading asset.
Another measure is a risk-weighted asset, which tries to compare the amount of equity a bank has to those risk weighted assets.
So, that’s a big element to the reforms, but there have been areas of reform to liquidity. So, making sure banks have more available sources of cash to weather a short-term period of disruption.
Also, more stable sources of funding. So, they are more enduring rather than running out of access to its funding sources were required. If you know that was the problem when Northern Rock which ran out of access to funding; but also things like trading, so transparent trading arrangements, aspects of structural reform. We just finished here in the UK the ring fencing, where retail banks have been ring fenced from the rest of the banking group.
Really it is a whole wide package of reforms, designed to improve the resilience of the banking sector across the board.
Laura: Why did AFME approach you to do this study?
Nick: A number of reasons, one was that at the time of the crisis a lot of regulators did what we call ex-ante studies, forward looking studies, ‘what might happen when these reforms get enacted?’ Whereas now, we’ve had 10 years. We can actually start to see what has really happened. We don’t have to make predictions or forecast. We can say, ‘well let’s see what happened, and really learn from what we’ve seen has happened to date.’ That was one reason for doing the study.
The second was to really look at regulation in a cumulative way, not just individual regulations, but actually how do they all collectively impact the banking sector, and particularly at the product level. So, product by products, how do those regulations have a cumulative impact.
Thirdly was to really understand the response of banks. I think, going back 10 years ago, we and policy makers didn’t really know how the sector would respond to the regulation. There are number of ways that bank can respond. They can increase the prices. They can cut costs. They can also shrink their levels of activities. Trying to understand those differences is the key motivation of the study.
Laura: How did you go about investigating these three key issues?
Nick: Like any economic study – there are a couple of things I will bring out. Firstly, was the importance of data. We learn at undergraduate studies at university that data is the foundation of all good analysis. If you have rubbish data, your analysis is going to be rubbish. We spent a lot of time getting a lot of detailed granular data, and this was data from across the number of banks, 13 banks, but also across the different products. The product being, foreign exchange, or equities, or bonds. There are different kind of products that banks have in their capital market activities.
So, this is very granular data, which we hadn’t seen or used before. That was the one big feature of the approach to get into that level of granularity.
Secondly, we tried to look at regulation in a cumulative way. We created an economic cost measure that allowed us to combine things like operational costs, but also financing costs, and opportunity costs. We put them altogether, and that way we can compare very different regulations, whether it’s a trading activity regulation, or whether it’s a capital regulation. You can bring all together and combine them in one way.
Then thirdly, because you never know quite what’s driving things, this is where multivariate econometric analysis comes in really helpful. That allows us to look at multiple drivers and really explain what’s going on. It is a great tool for economists to use, and to really unpick what was going on.
Laura: So, you drew on quite a vast tool kit for a complex question, and what results did you find?
Nick: There are two interim results of the study. Firstly, we did find that banks capital market activities have shrunk a lot over the period of 2010 post crisis, to 2016. In aggregate terms, it is about 39% shrinkage. We found that shrinkage was really variable across products. In some areas, activities have, if anything grown over this period; and some have shrunk quite markedly.
So, that product level variation is quite helpful, as that really helps you understand why the shrinkage might be happening, hence doing the analysis with the product level data. That was the first main finding. That’s helpful to explain to the regulators that shrinkage has been a response to regulation as opposed to increasing prices or cutting costs that I mentioned earlier.
The second finding was all about why, so why have we seen the shrinkage, can we understand, and can we find out what’s driving that shrinkage. To do that we used this multivariate regression analysis. What that involves is getting data on potential drivers. We looked at macroeconomics and quantitative easing: is that a driver? We looked at technological trends: does that explain why certain areas have increased or reduced in size? We looked at profitability. We would expect more profitable areas to expand and less profitable areas to contract or shrink.
We also looked at banks themselves. Some banks had a better crisis than others. They came out in a better shape, where some required tax-based support really struggled, so there was clearly variation across those banks.
We’ve got data on all those potential drivers, and then put them into multivariate econometric approach, and that nicely allows us to all see what’s really been driving things.
What we found was that our cumulative regulation driver was a big driver of the shrinkage we had seen, the others had some role, but not as big a role as the regulatory driver. So, it was really helpful and picking out and showing that regulation has a big impact.
Laura: Does that mean that the regulation was successful?
Nick: That’s a really tricky question. In some respects, regulation did want to reduce some aspects of banking activity to make it more sound and robust. So, it is not that shrinkage is good or bad, or regulation has gone too far, or not too far. It is more subtle than that. What the study shows is that there is a transmission of regulations onto banks and how they are impacted, and how that will impact markets and consumers and the like. So, it’s important illuminating that impacts channel.
What we cannot really say is whether regulation went too far or not too far, but all we can say is, because there is an ongoing cost of regulation, we need to be very careful with future regulations that we are getting that trade-off right. Are there continuing benefits to more regulation in comparison to the cost that we have identified in this report?
So, it really helps us to, I think, refine where the end point will be, but it doesn’t answer the fundamental question of, has there been, or is there too much regulation.
Laura: In any case, to me that really brings out your earlier point, the value of exposed evaluation rather than just ex-ante, and I guess also the power of using both, to complement each other.
That’s really interesting, but I also actually think this is a really great lesson in how important it is to have really good data, that is a point that always seems to come back, and especially the beauty of this study seems to me, is that you manage to look at it from such a granular level with such rich data, but that also allowed you to come up with a really solid econometric approach to get an overview of what is really driving things in the overall market.
Thanks so much, Nick. It has been really interesting to talk about this.
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