Financial regulation: Making banking an increasingly risky business?

In the wake of the financial crisis of 2008 there was a global move towards tightening up financial regulation.

The aim was to create a more stable economic environment to make it less likely that banks would engage in risky behaviour which could ultimately jeopardise their existence, and the wider economy.

In recent years, however, the mood music has changed again. Against a backdrop in many countries of needing to achieve economic growth, there has been a push from governments for financial regulators to embrace more risk, and to do more to attract banks to base themselves and their key operations in their country.

The top financial centres in the world, according to the Global Financial Centres Index, are New York, London, Singapore and Hong Kong. And the regulators of three of them – the UK’s Prudential Regulation Authority (PRA), the Monetary Authority of Singapore and the Hong Kong Monetary Authority – have an explicit objective to make their financial centre more competitive. Only New York currently has not gone down this route.

The challenge for regulators is to balance this desire against their responsibility to provide financial stability. And the key tool that regulators have is the stringency with which they choose to regulate any given bank.

How onerous regulation is for a bank is a choice. Regulators can choose to be more or less strict in the way they judge a bank’s risk. They can adjust the volume of communication they require and the degree of data reporting requirements they impose.

In practical terms all these choices determine how ‘light-touch’ a regulator wants to be for a bank.

Working alongside researchers from the Bank of England, we sought to investigate how the inclusion of growth and competitiveness into regulators’ objectives influences their policies.

In particular, we wanted to explore whether such a move would inevitably lead to a ‘race to the bottom’, where regulators would compete with each other to create the most favourable environment for banks.

When does growth-focused financial regulation increase risk?

We developed a game-theoretic model in which financial regulators compete to attract internationally mobile banks by offering regulatory stringency deals. The regulators accept that some banks are more likely to be willing to move locations than others, and the regulator needs to meet both financial stability and growth objectives.

One thing that emerged, which we hadn’t anticipated, is that the implications for the levels of financial regulation, both at home and abroad, very much depend on whether the central bank that’s coming under pressure to win business over to their country was more or less competitive before that pressure was applied.

Essentially, we found competitive deregulation will not arise if the relatively growth-focused regulator becomes even more so. In fact, a mandate from governments to become more focused on growth can, in this case, lead to improved levels of financial regulation and less volatility.

But competitive deregulation becomes more likely if the relatively stability-focused regulator becomes more growth-focused.

An example will help. Suppose for the sake of argument that London, before the new Government mandate, was less growth-focused than Hong Kong, but more growth-focused than the EU.

Increased pressure on London for growth, and allowing for the competitive response from the rival jurisdiction, would lead to overall stronger regulation on banks which could only threaten to move between the EU and London.

In effect the EU, in this example, gives up a little as any improvements in any deal they are willing to offer banks would likely be matched by a newly aggressive London.

But regulation on banks which could credibly threaten to move between London and Hong Kong would weaken as a cycle of competitive deregulation ensued. London, in this example under pressure for growth, would feel the need to sweeten the deal to stay or relocate in London.

While the more aggressive Hong Kong (per this example) would not take this lying down.

The conclusion is that the impact on regulation at home and abroad very much depends on where the recipient of that message was in the race before they were urged to do more.

Is financial deregulation a race to the bottom?

Competition pushes levels of regulation down, and leads to unpredictability in global levels of financial regulation, but it doesn’t necessarily result in minimal levels being imposed. Banks themselves do not want minimal levels of regulation. And often banks will still get more regulation than they ideally like.

Even in the competitive deregulation case then, there need not be a race to the bottom. However, if the damage caused by a bank failure in a given market is thought to be small, then the regulators will not be able to help themselves – and a race to the bottom ensues.

By counting the ratio of growth versus safety-focused words in the annual reports of the world’s major regulators we established a dynamic measure of growth-focus for the world’s financial regulators.

This ranked Hong Kong and Singapore as the most growth-focused, the US in the middle, and the EU and UK the most stability-focused. Though since the growth mandate the UK’s position has started to move.

The examples above are consistent with this finding: the more the UK is encouraged to go toe-to-toe with Hong Kong or Singapore the bigger the risk of a competitive spiral of deregulation kicking in.

It’s also important to point out that whether banks are attracted to a particular country is not just down to the regulatory environment. Governments can themselves influence this, whether positively or negatively, through issues such as tax rates, labour laws and openness to immigration.

Implementing global regulatory standards would help limit the extent of competitive deregulation, although in practice this is unrealistic due to specific local or regional requirements and the likely difficulty in gaining agreement.

A more realistic aim would be for individual governments or countries to set hierarchical objectives, such as making growth secondary to stability, as in the case of the UK’s PRA.

This could enable regulators to define and monitor a set of quantitative indicators for its primary stability objective, making it less likely that we end up in a race to the bottom or the kind of situation seen in 2008.

The views expressed in this article are those of the authors and do not reflect the views of the Bank of England, the PRA or any of its committees.

Further reading:

Should the Bank of England introduce tiered remuneration?

Regulatory transition could be impossible for some stablecoins

How big should the central bank balance sheet be?

Is ring-fencing UK banks really necessary?

John Thanassoulis is Professor of Financial Economics and is a Panel Member for the UK Competition and Markets Authority. He teaches Comparative Central Banking and Financial Conduct, Leadership and Ethics on the MSc Global Central Banking and Financial Regulation.

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