David T Llewellyn, Professor of Money and Banking at Loughborough University and Chair of the European Banking Authority’s Banking Stakeholder Group (BSG), looks at the importance and need for the principle of proportionality in banking regulation.
BRUSSELS, 14 June 2016 – The regulatory pendulum has a long history as bank regulation swings between more/less intensity, coverage and complexity. There was a clear ideology in the years running up to the crisis which spawned "light touch" approaches to regulation. Banking crises inevitably bring forth more and different regulation of banks, and the recent global crisis is no exception. As a result, in the years after the crisis there has been one of the biggest-ever reforms in the international regulatory regime and (most especially with respect to the EU) and also in the basic regulatory architecture.
The BSG judges that it is now time for regulatory authorities to take stock of how regulation has evolved since the onset of the crisis in 2007.
In the interests of effective and efficient bank regulation, the Principle of Proportionality needs to be recognised and applied at every step of the legislative and regulatory process so that existing and new legislation and regulations are applied to banks and financial institutions in a proportionate way. The overall administrative resources and cost of new regulation – such as supervisory costs and new IT systems – have a substantial impact on all banking institutions, and an even more severe impact depending on criteria such as the size and complexity of institutions and their business models. As a result, disproportionate regulation could inhibit small banks from providing finance to the real economy to support innovation and growth.
The importance of proportionality
There are many reasons why proportionality in regulation is an important requirement:
- Regulation imposes costs: resource costs of the regulatory agencies, compliance costs imposed on regulated firms, and customer costs to the extent that the costs of regulation are passed on to customers.
- Regulation might induce changes in bank business models which are not necessary for the achievement of the regulatory objectives.
- An impression can be created that disproportionate regulation means that regulators are effectively taking over the management of banks by limiting bank managers' discretion and de facto limiting the controlling role of the Board of Directors.
- Disproportionate regulation may induce arbitrage within the banking system if, for any reason, regulation impacts disproportionately on some types of banks. It is also likely to induce a process of disintermediation towards less-regulated institutions and the capital market.
- Disproportionate regulation may compromise competition in the banking system. by increasing barriers to entry. Regulation tends to impose a disproportionate burden on small players in the market and new entrants, which can make it harder for them to compete with more established players.
- Furthermore, regulation tends to be particularly costly for small institutions, partly because of the fixed costs that compliance systems involve.
Disproportionate regulation may also generate wider costs on the economy whenever some of the basic functions of the financial system (financial intermediation, optimal risk shifting, etc.) are compromised or made unnecessarily costly.
In the final analysis, proportionality is about balancing the costs and benefits of regulation: if regulation is disproportionate in relation to its objectives, the cost-benefit calculation is likely to be worsened.
The five pillars of proportionality
The Principle of Proportionality has several dimensions each of which raise different issues with respect to costs and benefits for all stakeholders. Five pillars are identified:
1. Objectives: whether a particular regulation that is designed to apply to all regulated institutions is disproportionate in relation to the objective sought.
2. The totality of regulation: whether the totality of regulation (as opposed to each regulation taken alone) is disproportionate for the key regulatory objectives, given the possibility of diminishing marginal returns that may emerge if regulation is taken beyond its optimal level in terms of scope and intensity. A situation can arise in any regulatory regime where each individual regulation might be justified on cost-benefit criteria and yet, due to a process of regulatory escalation, the totality of regulation might be disproportionate in terms of costs exceeding benefits.
3. Excess Complexity: whether regulation is excessively and unnecessarily complex for the objectives that are sought and whether the same regulatory objectives could be achieved, and with the same degree of effectiveness, with less complex regulatory requirements.
4. Differentiations: whether, in the application of a regulation, sufficient differentiations are made between different types of banks without compromising the regulatory objectives.
5. Materiality: whether a particular regulation either applies to institutions to which it should not be applied (the materiality principle) and/or to institutions which are subject to a costly new regulation when they are only marginally exposed to the risks that such regulation aims to control.
There are several reasons for concern about the potential for excess complexity, some of which have been raised by some regulators and academic analysis:
- The consensus appears to be that complexity of regulation and its application results in excessive costs of compliance.
- This may in turn have the effect of raising entry barriers in the industry and in the process compromise the competition objective.
- It can make compliance more superficial, turning it into a box-ticking exercise.
- Complex rules often have high costs of information collection and processing. Again, this is likely to be a particular burden for smaller institutions.
Complex rules have the potential for regulatory arbitrage and greater gaming of regulation by regulated institutions making it more difficult to identify when rules are being gamed.
A more general feature suggested by Haldane of the Bank of England is that "the more complex the environment, the greater the perils of complex control." Financial products and financial activity have become more complex, and regulation will necessarily have to reflect this fact. However, in many cases regulation has become more complex and detailed than the regulated business and products require.
A major dimension to proportionality relates to differentiation: the extent to which regulation applied to particular classes of banks should reflect their particular circumstances. The BSG report highlights in particular the issue of reporting to regulatory agencies and the burden that this imposes on smaller banks.
Such differentiations might relate to, for instance, size, business models, ownership structures, risk profiles and systemic significance, etc. Imposing similar requirements (the one-size-fits-all syndrome) on small and large banks in certain aspects of financial regulation may result in undesired effects, as the former would face proportionately higher costs while their systemic significance is low.
On the basis of the analysis of the broad concept of proportionality, and the six case studies contained in the BSG report, a series of general recommendations are made in addition to those specifically related to the case studies:
The principle of materiality and the definition of the Principle of Proportionality should be published in a harmonised, horizontal ESAs guideline and thus be consistently applied. This has become even more important due to the banking union and the work on single rulebooks and supervisory handbooks.
Banks and financial institutions, to which the Principle of Proportionality should apply, should be defined with a flexible scope. As argued above, several criteria could be used, such as bank: size, business models, degree of interconnectedness, and availability of substitutes for services, the extent of global (cross-border) activity, complexity, liquidity risks, maturity mismatches, and group structure/ownership structures.
- A high-level Task Force should be established by the European Commission to further elaborate on the issues within the concept of proportionality and propose specific actions and recommendations for implementation in the financial industry. Sufficient resources (manpower and financial) need to be allocated to secure a quick response to its mandate
Regulatory agencies could usefully establish within their organisations semi-autonomous Proportionality Review Groups accountable directly to the Chair and Chief Executive of the agency. In addition to making regular reports to the Chair and Chief Executive, these internal groups should also be consulted at an early stage, and become an integral part of, the process when new regulations are being proposed.
There should be regular independent reviews of the issue of excess complexity, and of the application of the Principle of Proportionality and its balance with other objectives of financial regulation, in particular fair competition and a level playing field. Such reviews should be requested periodically by the European Commission to third parties, such as major consultancies or academics, and their results should be made public and considered by the Commission and the ESAs in their future work plans.
Cost benefit analysis should be applied not only to individual regulatory requirements but also to the totality of regulation.
- There should be a systematic review of supervisory reporting requirements with a view in particular to removing unnecessary duplication and introducing more differentiation as between different types of institution.
A particular dimension to be considered is the extent to which a proposed regulation might not be competitively neutral. In particular, consideration should be given to making adequate differentiations between different types of institutions, and especially whether some regulations impose a disproportionate cost on different types of institution (in particular small firms) without generating any significant benefit in terms of regulatory objectives.
The need for rigorous cost benefit analyses to be made for all regulation underlies many of the recommendations made in the BSG report. It has to be recognised, however, that the precise quantification of costs and benefits is extremely difficult. The main purpose of cost benefit analyses in these cases is not so much to generate precise figures but to act as a discipline on regulators.
- The author is Professor of Money and Banking at Loughborough University and Chair of the European Banking Authority's Banking Stakeholder Group (BSG). He wishes to thank all members of the BSG for their invaluable contributions to the research behind the writing of the report Proportionality in Bank Regulation from which this article draws heavily. The full report is available at: www.eba.europa.eu/bsg.