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Ensuring that banks hold enough capital to withstand a moderate crisis is a critical part of macroprudential policy and was a key response to the 2008 crash.
In 2010 the Basel III regulatory reforms allowed regulators to require banks to increase capital held during financial upswings and reduce it during downturns.
Some argue that the time is right for loosening capital requirements to encourage financial institutions to keep lending, although there are warnings that this will increase the risk of a future crisis.
Finance Watch warns that easing bank regulation and supervision could further increase the risk of a financial crisis and cautions against abandoning requirements for banks to hold more capital in times of crisis.
Researchers at the Bank for International Settlements outline a quantitative assessment of the impact of releasing bank capital buffers in response to the crisis. In the event of a financial crisis similar to 2008 it warns that without loosening regulatory requirements lending would severely contract.
Breugel suggests that existing bank capital requirements are not enough to avoid major crises. It proposes a tighter set of capital requirements for those parts of the system that are the most leveraged.
Excessive risk-taking in the financial industry could be disincentivised and how much people are paid and the way profits are distributed can play an important role.
Goldman Sachs made headlines by taking the decision to retain its dividends payout despite the Federal Reserve’s guidance against doing so. The UK’s Prudential Regulatory Authority has already requested that banks scrap dividends distributions throughout the Covid-19 pandemic, as have many other national regulators.
Some proposals go further, arguing that after anti-banker sentiment following the financial crash, the current crisis is the time for regulators to require that ethical banking become the norm.
The Bank for International Settlements argues that policymakers should impose blanket constraints on profit distribution and that authorities should attempt to harmonise these measures across jurisdictions.
The Centre for American Progress argues for a suspension of all distributions, including discretionary bonus payments, instead focusing on rebuilding capital.
Professor Nizan Geslevich Packin argues in Forbes that policymakers should introduce new measures to promote ethical banking during Covid-19. Her recommendations include a new fiduciary duty for banks, and for them to be required to be flexible with customers facing difficulties.
While the 2008 financial crisis centred on the banking sector, the Covid-19 crisis has shown that there are huge vulnerabilities in other parts of the financial system – often referred to as the shadow banking system. Shadow banking entities offer services that are similar to those provided by commercial banks but are not regulated in the same way. They include some investment banks, mortgage companies and firms that deal with securities.
This lack of regulation means that shadow banking contains the most immediate risks to financial stability as a result of the economic downturn, as a result of poor regulation for the last decade. Some argue that particularly systemically important non-bank financial institutions – such as insurance companies or other institutions that might be seen as too big to fail – must also be protected and regulated to protect the integrity of the financial system as a whole.
Professor Enrico Perotti argues in a column for Vox EU that the coronavirus shock poses a serious liquidity risk for the shadow banking sector and that support to this part of the financial system is critical.
The Financial Times editorial board has argued that policymakers were right to introduce regulation that began to shift risk from banks to non-bank financial institutions, and that investors should be prepared to lose their capital during this crisis.
Mark Sobel, chairman of the US Official Monetary and Financial Institutions Forum, recommends that policymakers undertake a review into the shadow banking sector when this crisis is over to determine what went wrong and what fixes are needed. He identifies several failures in regulating this sector and that financial stability is under threat.
Over the long term, there are proposals for the better use of macroprudential tools, financial policies that aim to ensure the stability of the system as a whole, to strengthen the resilience of the finance sector and equip it to better deliver on wider social objectives, such as building a net zero economy.
This includes rehabilitating credit guidance – rules on how credit should flow to particular parts of the economy, such as green investments.
The UCL Institute for Innovation and Public Purpose argues for the reintroduction of credit guidance. It suggests this could deliver productive investment in a low-carbon economy, steering away from less productive and risky finance.
IPPR’s Commission on Economic Justice recommends using three major macroprudential tools to limit credit to the financial sector and contain rising asset prices. One of its proposals is for the Bank of England to adopt a target to limit house price inflation.
