Bank regulators everywhere are pressing ahead with an overhaul of bank regulations. Some bankers and policy-makers have opposed the proposed changes. They argue that we might end up with regulatory overkill. It is clear that getting the balance right will be a long and arduous process. One can only hope that, by the time the reforms come through, it is not too late. Some of what is to come is clear enough, while others are still in the realm of discussion. Banks will have to deal with higher capital requirements. Basel 3 has proposed core equity, that is, equity, reserves and surplus, for banks of 7%. This is only the minimum across the system. Over and above this, around 30 of the world's biggest banks, deemed 'systemically important', face additional core capital requirements of up to 2.5%. Higher capital is the one thing on which we have some certainty and yet this does not reassure everybody. There are some who believe that core equity should be even higher - say, 15-20%. In the recent financial crisis, it is estimated that US banks lost nearly 7% of their assets. If we accept that banks need a minimum of 8% tier I capital in order to run their business, that adds up to a tier I capital requirement of 15%. Banks argue that holding more equity will increase their cost of capital and will result in higher costs for their borrowers. That, in turn, will translate into lower economic growth. They are wrong. Higher equity will lower the perceived risk of banks and hence cause the cost of capital to fall. So, it is not bad for borrowers. It may be bad for bankers because it will cause return on equity to decline and this will mean lower bonuses for bankers. Is it bad for investors? Not really. The return on bank equity, under the present conditions, is fictional. Investors earn high returns on equity for a few years. Thereafter, when a bank fails or if a banking crisis strikes, the return is wiped out. It is better for investors to live with lower returns that are stable. Higher capital apart, there are some radical proposals on the table. The US is planning some form of the Volcker Rule which would restrict banks' involvement in proprietary trading. This is intended to effect a clear separation between retail banking and investment-banking type activities. Some have questioned whether the integration of retail and investment banking is indeed the cause of instability in banking. They point out that pure commercial banks, such as Northern Rock in the UK, were not exempt from failure. The Vickers Commission in the UK has proposed a compromise. Banks can have retail and investment banking activities. But retail activities, namely, deposits and small loans, will be 'ring-fenced' from both wholesale and investment banking through higher capital requirements, say, 10%. Other banking activities can have lower capital. The idea is that, when a bank fails, the retail bank is insulated by a large enough capital cushion.
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