Taking Stock of Bank Regulatory Reforms Ten Years After the Failure of Lehman Brothers

Year 2018 marked the 10th anniversary of the global financial crisis (GFC), one of the most severe since the Great Depression. These ten years have been characterized by intense regulation of banking sectors across the world, especially in advanced countries. The crisis has also reignited the debate about the right blend of regulation and market discipline to ensure the safety and efficient functioning of banking systems.

Although there have been much research and discussion on the topic, there is a lack of systematic evidence on the detailed reforms undertaken by advanced and developing countries. In our article ‘Bank Regulation and Supervision Ten Years after the Global Financial Crisis’ we summarize developments since the GFC in capital regulation, market discipline and supervisory monitoring using information from the World Bank’s Bank Regulation and Supervision Survey (BRSS). The survey is a unique source of comparable data on bank regulations and supervisory practices around the world. This is the fifth time that the survey has been released and it allows researchers and policy makers to trace back developments in bank regulation and supervision since the GFC.

In our study, we show that higher capital requirements were imposed in both developing and high-income countries. Regulatory capital holdings—that is, regulatory capital divided by risk-weighted assets—improved significantly, especially for banks located in high-income countries. However, when we examine simple leverage ratios (ie equity over total assets), we do not find a similar increase. These two facts together suggest that increases in regulatory capital ratios are mainly due to reductions in risk-weights, which is problematic as regulatory capital requirements were mostly dismissed by market participants at the time of the crisis, since risk weights did not reflect actual risk. We also find that a wider array of instruments is now permitted to satisfy capital requirements, potentially inflating the value of the total amount of regulatory capital. 

Our research highlights the importance of narrowly defining capital. Specifically, we find that bank risk is more sensitive to changes in simple leverage ratios than regulatory capital ratios. In a series of empirical tests, we show that the link between capital and measures of bank risk (such as z-scores) is weaker in countries that have relaxed their definition of capital to include assets such as hybrid debt capital instruments, asset revaluation gains, and subordinated debt. Moreover, the relation between capital and bank risk is significantly weaker for large banks who are better able to manipulate capital ratios by reducing risk weights within their portfolios (eg through securitization), issuing securities that can be used as Tier 1 capital (such as subordinated debt), and have greater discretion in meeting capital requirements through internal ratings-based approaches that can be opaque.

Our paper also shows that market discipline may have deteriorated in many countries because of weaker incentives to monitor bank risk-taking. Financial safety nets became more generous, weakening depositor discipline of bank risk-taking behaviour. Similarly, government interventions in the banking sector to rescue failing banks undermined the incentives of market participants to monitor banks’ health. This will incentivize banks, especially large banks, to take on more risk in the future. Moreover, the information available to supervisors and regulators to assess bank risk did not improve substantially.  

Supervisory capacity did not keep pace with the extent and complexity of new banking regulations. The GFC gave impulse to several reforms increasing the number and complexity of regulations. The supervisory agencies have seen the burden of their task increase because of an evolving, increasingly complex banking business that they now need to oversee. Nonetheless, we document that there has not been a corresponding increase in supervisory powers and supervisory capacity. 

The findings in our paper echo some of the important messages of the recently released Global Financial Development Report 2019/2020. Specifically, bank regulatory agencies should pay attention to the incentives of banks and market participants, and design simple enforceable regulations that are less likely to be circumvented by regulated entities. 

Deniz Anginer is Assistant Professor in Finance at the Simon Fraser University.

Ata Can Bertay is Assistant Professor in Finance at Sabancı University.

Robert J. Cull is Research Manager at the World Bank.

Asli Demirgüç-Kunt is Chief Economist, Europe and Central Asia at the World Bank.

Davide Salvatore Mare is Research Economist at the World Bank.