How banking regulation has grown out of all proportions

Over the last forty years, banking regulation has grown extensively. The framework developed by the Basel Committee on Banking Supervision alone consists of two million words. What is actually stated in all these documents?

Marie-José Kolly and Jürg Müller[1]

A bank fails, and politicians save it with taxpayers’ money. This story repeats itself all around the world, most recently in Russia and Italy. To prevent such costly bailouts, banking regulation has been devised and implemented for a long time. The documents of the Basel Committee on Banking Supervision play a key role for national rules.

The Neue Zürcher Zeitung (NZZ) analyzed these regulatory documents in detail. Its data team included all 163 regulatory documents with final status as of 31^st of July 2017 in their analysis (see «Methods» part at the end of this article). Major elements of this regulatory framework are Basel I (the first Basel capital accord, 1988), Basel II (2005), and Basel III (2010).

The most obvious development is the sheer growth of text over the years. Figure 1 shows, for the past 40 years, how much new text the Committee has published per year.

The Bank collapse that stood at the beginning

The publications from before 1988 mainly prepared «Basel I», the first global standard for capital requirements. Unsurprisingly, the motivation was a bank collapse: the insolvency of the German Herstatt Bank in 1974, the biggest bankruptcy in Germany after World War II, triggered a global coordination in this matter. Herstatt was closely intertwined with international financial markets, and its collapse sent shockwaves around the globe. It prompted central bankers of the economically leading countries to hatch out the first Basel Capital Accord.

After introducing Basel I, the committee soon realized that further changes and amendments were required. Banks started to «innovate» their way around the constraints imposed by regulators, and forced them to react. And with that, a «whack-a-mole» game started between banking institutions and regulators that lasts to this day.

The resulting regulatory wave reached a first peak in 1999, also due to the long-forgotten Millennium Bug. The Basel Committee on Banking Supervision published three documents discussing the impact of the millennium change on the IT infrastructure and the resulting dangers for financial stability.

The Financial Crisis of 2007-08 as an Accelerator

In the first decade of the new millennium, the Committee stepped up their game and accelerated their publication schedule. Their lawyers and economists developed, published, and calibrated Basel II. These efforts turned out to be futile though. They did not prevent the financial crisis of 2007-08, a widespread banking panic, and bailouts on unprecedented scale by governments all around the world.

During the financial crisis of 2007-08, however, the publication activity by the Committee slowed down remarkably. One can assume that regulators and central bankers were just too busy firefighting and did not have time to think about what the Financial Crisis of 2007-08 means for the regulatory framework. After the most urgent crisis management was done in 2009, the respective work was taken up again. After all, it had to be acknowledged that Basel II failed and that it was time for something new: Basel III.

In the aftermath of the financial crisis, the Committee has published 2795 pages. This is more than half of the entire regulatory framework consisting of 5440 pages and 2 million words – the Basel framework has reached an epic dimension.

Hard to Digest

The Basel documents are not only thousands of pages long, they are also a hard read. An average sentence in the Basel documents consists of 25.7 words, often embedded into complex grammatical structures. In comparison, an average sentence of the British National Corpus, which is a collection of texts covering a broad range of modern British English, only consists of 21 words.

Already the second sentence of the very first document published by the Basel Committee on Banking supervision spans over 72 words.

How much Banks «should» and how little they «must»

The word should appears prominently within the Basel documents. It’s the third most frequent word after «banks» and «risks», excluding function words such as «and», «the», or «in». Of course, regulations describe what banks and other actors «should» do. But explicitly binding verbs are much rarer: the word «must» only appears 5102 times, less than half as often as the word should (13’926 times).

The graphic shows that this pattern is consistent over the past 40 years. Notwithstanding, in the aftermath of the financial crisis of 2007-08, regulators leaned more towards committing verbs like «need to», «be required to», «shall», or binding verbs like «have to» and «must».

In 2008, the Committee only published two documents. The longer one was published shortly after the fall of Lehman Brothers in September 2008. It is the document with the highest ratio of the word «should» relative to the overall number of words. The word «must» only appears in this document once.

Furthermore, the Committee puts the focus on recommendations, and not on prohibitions. The negations «should not» and «must not» only account for 3.7% of the appearances of «should» and «must», «shall not» only account for 12.8% of the appearances of «shall»

A large part of banking regulation seems to be formulated as a mere recommendation. This soft tone could stem from the fact that the analyzed documents set international standards, and not binding national law. They have to be translated into national law before they become binding for banks.

Risks Everywhere

Risk is the second most frequent word after «banks» in the analyzed documents. The regulatory texts, the five most frequent risk categories are ones that could endanger banking institutions.

• «Credit Risk» is the financial risk of being in a money lending business. It is the risk that a debtor defaults on his or her loan.
• Banks fund long term investment or grant long term loans with short-term liabilities like deposits. This funding mismatch creates «liquidity risk». A bank could lose access to short term funding, for example when many depositors «run» on their bank.
• «Interest rate risks» arise when holding fixed rate bonds, for example. If the market interest rate rises, these bonds suffer losses. A bank may struggle even more if it funded fixed rate bonds with short term deposits on which it has to also pay a higher price after interest rates increased
• «Market risk» is a very generic term. The price of any asset, a stock, a currency, or a commodity, can change at any time for any reason – for example, because of a terror attack or a flood. Price fluctuations create risks for holders of these assets.
• «Operational risks» are risks any company faces, not just the ones engaging in financial markets. Human error or technology failure can lead to unanticipated losses.

The prominence of these 5 risk categories in the Basel documents fluctuated over the past years. This graphic shows the average ratio of how often these risks were mentioned versus the amount of all words per year. This view allows to compare the relative importance of risk categories over the years.

The first documents in the 1970s and 1980s mentioned these risk categories rather rarely – in fact, the first document published in 1975 did not mention the word «risk» at all. Up to the mid-1990s, credit risk, a classic risk for financial institutions, dominates.

During the financial crisis of 2007-08, the Committee did not publish much. But when it published, it focused mainly on operational risks (2007) and liquidity risks (2008). Although the documents are not a direct response to the crisis, recent events have highlighted the relevance of the publications published:

Operational risks are a rather new member of the Basel risk family. Operational risk is also the most generic risk category. The increasing prominence of operational risks over time demonstrates the expanding scope of the Basel framework. Danger looms everywhere; and regulators are keen to identify any potential risk, and of course to regulate it.

How Risks are managed

One of the most frequent word pairs in the analyzed text collection is «risk management». The Basel Committee relies on a number of instruments to manage risks; these can be attributed to five categories.

The graphic below indicates how often these instruments were mentioned in the Basel documents relative to the total number of words in a document, on average over the years. Overall, the increasing variety of instruments suggests that the framework became increasingly specific over time.

Before 1990, the Basel Committee on Banking Supervision focused on traditional capital requirements. Simple capital requirements tell banks how much equity they need on their balance sheet compared to their size. Size is not everything though. Traditional capital requirements adjust the required equity ratio to the risk of the positions a bank is holding. The higher the perceived risk, the more equity a bank is required to hold.

In the 1990s, new instruments were added to set the stage for the three pillars of «Basel II»: capital requirements, supervisory reviews, and market discipline.

Supervisory Reviews describe both internal and regulatory controls for banks. Market discipline is expected to arise with transparency and extensive public disclosure requirements for banks. The committee hoped that well-informed investors would prevent or at least sanction excessive risk taking by banks. By 2007 it was clear that this hope was unfounded.

Consequently, market discipline more or less disappeared from Basel documents after the financial crisis of 2007-08. Other instruments became much more important: liquidity requirements («liquidity coverage ratio», «net stable funding ratio») and new capital requirements («Leverage ratio», «total loss absorbing capacity», «countercyclical [capital] buffer», «capital conservation buffer»).

The rise of liquidity requirements that we can see from the data corresponds with the events of the Financial Crisis of 2007-08. This crisis was triggered by a bank panic within the shadow banking sector. Banks lost access to short term funding and had to fire sale financial assets with longer tenors. Liquidity requirements have been implemented to make banks more resilient when funding dries out quickly.

New capital requirements also incorporated lessons from the Financial Crisis of 2007-08. With traditional capital requirements according to Basel II, banks can use internal risk management models to determine the risk weights underlying the capital requirements. However, banks used this leeway to systematically underestimate their risks. In hindsight, the unweighted equity to asset ratio was a far better indicator to predict which banks were going to fail. Therefore, the Basel Committee on Banking supervision complemented the risk weighted traditional capital requirements with an unweighted Leverage Ratio.

However, the leverage ratio may not have the stabilizing impact the Committee is hoping for. Before the financial crisis of 2007-08, banks tried to minimize the impact of capital requirements by underestimating risk weights. They did not care about their unweighted equity to asset ratio. This has now changed. In the future, financial institutions are likely to find ways of creatively circumventing the new capital requirements.

Complexity comes at a heavy price

The Basel rules change rapidly. This was already the case before the financial crisis of 2007-08. Nothing suggests this will change anytime soon. Constant patchwork has been required from the beginning. The newest edition, «Basel III», also did not fundamentally change the framework. It just extended it massively. And with this, the complexity of the Basel framework has become overwhelming.

The Basel documents are only the peak of the iceberg. They get translated into national laws, directives, and guidelines. Thomson Reuters monitors changes in financial regulations around the globe and registered, on average, 200 regulatory changes in 2015 and 2016 – per day.

Banking regulation has grown out of all proportions, which is tremendously expensive. In 2014, Deutsche Bank alone paid 1.3 billion Euro to cope with regulatory change, while JP Morgan hired approximately 13’000 additional employees between 2012 and 2014.

One could argue that banks earn enough money and can cope with these additional expenses. But these costs hit the entire financial industry and the financial institutions pass them on to their clients. Furthermore, all these regulations create high barriers to entry, stifle innovation, and hinder competition. Both these effects result in higher costs consumers and companies pay for financial services. In the end, we all have to pay a heavy price for complexity.

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[1] The original article has been awarded second place in the Swiss Press Award Online. It has been first published in Neue Zürcher Zeitung (NZZ), the Swiss newspaper of record: https://www.nzz.ch/wirtschaft/40-jahre-bankenregulierung-unter-der-lupe-die-worte-welche-die-naechste-finanzkrise-verhindern-sollen-ld.1304103 (assisted by Simon Wimmer, Joana Kelén and David Bauer, in German)

Methodology

Choice of texts
The text corpus englobes all 163 «Standards», «Guidelines» and «Sound Practices» which the Basel Committee on Banking Supervision published as of 3 July 2017 – and only the final versions. The Committee’s further publication types are not regulatory but rather descriptive or other texts.

Analysis of the amount of text
Pages were counted in the PDF-documents published by the Basel Committee. Four of the 163 publications did not appear as PDF- but only as HTML-document on the website of the Basel Committee. In these cases the according number of pages in a Word-document with font Times New Roman and fontsize 12 was used.

Text analysis: Sentence length
For the calculation of sentence length, a sentence was defined as a word string followed by a fullstop, question or exclamation mark and a space. In this way, decimal points – among others – could be excluded.

Text analysis: Modal verbs
The text collection was searched for the following modal verbs and modal constructions: «must»; «has/have to»; «is/are [not] obliged to»; «is/are [not] required to»; «needs/need to»; «shall»; «is/are [not] supposed to»; «ought to»; «should».

The verbs and constructions that were chosen to figure in the graphic (and, therefore, used for calculating proportions) each appear in the text corpus more than 100 times; the others less than 10 times. The degree of necessity or commitment expressed by these modal verbs or constructions was shown according to a publication of the Harvard University and to discussions with linguists. Tokens of the verbs or constructions respectively were counted per documents and summed up to categories. Then, the proportion of each category was calculated relative to the total count of chosen modal verbs and constructions. For each year, the mean value over all the documents that appeared in this year is shown.

Text analysis: Risk types and instruments
As for modal verbs, the text corpus was also searched for particular risk types and instruments. Here, too, different morphological and orthographic forms of the terms were used for the text search. Shown in the graphics were:
– the five most frequent risk types that appeared in the text corpus, i.e., «credit risk»; «market risk»; «operational risk»; «interest rate risk»; «liquidity risk»;
– the instruments which the Basel Committee describes, i.e., «capital requirements»; «market discipline», «supervisory review»; liquidity requirements («liquidity coverage ratio», «net stable funding ratio»); newer forms of capital requirements («leverage ratio», «total loss absorbing capacity», «countercyclical [capital] buffer», «capital conservation buffer»).

For each document, the proportion of each risk type or instrument relative to the total number of words was calculated. The graphic shows the mean value over all the documents that appeared in a year. This results in the «density» of a particular term or concept in a document or in a year – independent from the amount of text published.

Code
The code used for the text analysis was published on Github.