Will new bank regulations cause the next financial crisis?

By now, there isn’t much left to be said about the great financial crash of 2007-2008 that hasn’t already been said countless times before.

It’s been written about from every conceivable angle in countless books, blogs, newspapers, and magazines, featured as the subject of many a TV show and documentary, and even turned into a major Hollywood film starring Christian Bale and Brad Pitt.

Such widespread coverage -even almost a decade later- isn’t unwarranted. Widely considered to be the biggest economic crisis since The Great Depression back in the 1930s, the disaster threatened to destroy major financial institutions until government bailouts came to the rescue, caused unprecedented levels of mass unemployment, and forced banking regulation authorities to spend the next several years doing all they could to prevent such a catastrophe from ever happening again.

Yet as banks face spending the remainder of this year ensuring they achieve SA-CCR compliance before it comes into effect on January 1st, 2017, experts are now warning that these same regulations which aim to prevent another economic meltdown could well end up being the very thing that causes one.

Replacing current risk forecasting methods

One of numerous banking regulations put forth by the Basel Committee, SA-CCR (Standardised Approach for measuring Counter Credit Risk) takes the place of existing risk forecasting practices CEM (Current Exposure Method) and the SM (Standardised Method), and -when it comes into effect at the start of next year- will impact not just banks, but the entire finance industry.

It’s this one-size-fits-all approach to predicting potential risks that researchers from The London School of Economics’ Systemic Risk Centre (SRC) say could lead to an even bigger financial crisis than the one that struck eight years ago.

In a report issued last year, the SRC researchers argued against the idea held by banking regulators that it’s possible to have a single, uniformed model of forecasting future risk that is “knowledgeable and correct.” Further, the report’s’ authors suggest that by opting for one set of compliance regulations over another, those authorities stand every chance of “backing the wrong horse,” leaving banks vulnerable.

Cause for concern

Worryingly, given just how much banks are investing in ensuring SA-CCR compliance, these regulations -along with other rules stemming from the Basel Committee, were singled out by the SCR as a serious cause for concern.

According to the report, SA-CCR and similar methods “less accurately measured and forecast” risk than those they’re set to replace from 2017 onwards. Not the likes of CEM and SM were necessarily without flaws.

The SRC report goes on to state that whilst no form of regulation compliance currently in place -nor any set to come into force over the next two years- is 100% perfect, some could prove invaluable in safeguarding certain individual components of the global finance system.

Protecting individual components of the financial system

This stems from the belief the SRC suggests is currently held by regulators that, because these individual elements are secure on their own, the system as a whole is immune from a repeat of the 2007 – 2008 crisis.

The report’s authors suggest that the truth however, is that there is likely to be a number of economic imbalances in the system which are not only undetected now, but will continue to be so under the one-size-fits-all regulation, and that these imbalances could spell disaster in the future if they’re not detected by SA-CCR and similar banking regulation.

By sticking rigidly to this one uniform credit risk regulation, the likelihood that some problem will come to the fore increases. Since all institutions will have missed it by following a standardised method of forecasting risk, any weakness in the system will cause the entire global financial sector to suffer at once.

The alternative, encouraged by the SRC report, is to stop forcing all institutions to follow a single, industry-wide risk model. By doing so, the likelihood of at least some institutions using a model which ensures they’re prepared for an as-yet-unknown problem increases.

This will mean that rather than the industry as a whole winding up on the brink of another major collapse, those institutions who were ready can remain strong enough to support a recovery, ultimately saving the finance sector from dealing with consequences more far-reaching and even more serious than those of 2007-2008. In other words, the very same consequences banking regulators have just spent the better part of the past decade looking to avoid.