Bank regulation on the forefront

ECB announced their efforts to hold new stress testing for banks in the EU. This will be an important test for bank regulators and the quality of the financial system in Europe. It will get at one of the chief problems of the EU and central banks in general, the role of bank regulation and lending. I am becoming more of the mind that the bank lending channel is broken and that further monetary policy efforts like QE will ineffective if do not do a better job of having the bank loan transmission policy work.

The ECB will focus on the three pillars of bank regulation, supervisory risk assessment, asset quality review, and stress testing. All of these pillars are difficult to assess but will still have a critical impact on the money transmission process. If there are more restrictions on bank lending or on capital requirements from these stress tests, the bank lending channel will not work effectively. It will not matter what will be the rate set by the ECB, if banks are required to build their capital base.

The ECB is not alone in looking at bank activity. The Fed proposed new liquidity rules for banks last week. The new Fed liquidity rules will be, as stated by one Fed governor, "super equivalent" to the Basel III standard. The new Fed standards are expected to be implemented much sooner than the EU and Basel III standards. The standards will actually be tougher than what we see in Europe.There is a concern that there be will a limited amount of high quality assets available for banks.

There is also a concern that banks should have more liquidity or assets that can be sold within 30 days. The 30-day survival test is modified for institutions that are above $50 billion and not globally focused and will not apply to small institutions. However, the end result is that institutions who can create scale and diversify will be penalized. The net impact is that you cannot extensively lend to anyone accept the very best credits.

Again, the bank regulation will be at cross purposes with the stated goals of monetary policy which is to have more lending through lowering of interest rates. Interest rates are low and the curve is flat so you cannot make money on the spread in rates and the central bank regulator is forcing you to raise more capital. How is this good for getting money in the hands of borrowers at attractive levels? Capital ratios need to improve but micromanaging the banks is not the way to get this done.

Mark Carney also added new views on how the BOE will help banks. He used the specific words, "we are open for business". Forget about moral hazard, the BOE will provide liquidity to banks when needed. He is arguing that the BOE should be helpful to banks in a crisis and make sure they know that funds are available. This is contrary to the BOE approach of the past which was more suspect of providing funds. The BOE wants to make sure that London is still the global center for banking. They are imposing more regulation but they are also making funds more easily available.

Regulation and central bank behavior is diverging in the post-crisis environment. Some of the choices made are not helpful but there will be room for experimentation. we have to allow for regulation experiments.