“German regulators seized the ailing Herstatt and forced it to liquidate
on June 26, 1974. The same day, other banks had released Deutsch Mark payments
to Herstatt, which was supposed to exchange those payments for US dollars that
would then be sent to New York. Regulators seized the bank after it received
its DM payments, but before the US dollars could be delivered. The time zone
difference meant that the banks sending the money never received their US
dollars.”
Business Pundit, May 7, 2009
This failure has special place in the history of
banking regulation, as the following debates led to introduction of new
international regulation. This included well known Basel Capital Accords
introduced in 1988, which has mainly focused on banks’ credit risk management,
by setting risk-weighted minimum capital requirements. Unfortunately, bank
regulators seem to have failed to discipline banks.
OECD analysis shows a significant decline in
risk-weighted assets to total assets ratio over time. Historical development of
the ratio of 15 largest banks has declined from nearly 70% in 1990 to 35% just
before the financial crisis. Systemically important banks started moving to
unconventional business practices, which suggests that risk-weighted system of
calculation encourages banks to design instruments for bypassing the regulatory
regime.
“Commerzbank is to swap junior debt for shares to boost
core capital by €1bn and take the German bank closer to meeting European
regulators’ demands to shore up its balance sheet.”
Financial Times, February 23, 2012
By engaging in shadow-banking and other
unconventional banking activities, banks seem to forget about their core
function, which is prudential lending to credit-worthy enterprises and
households. The following table shows the percentage ratio of selected banks' loans to
their total assets.
Since Basel accords were implemented in 1992, the
percentage ratio of bank loans to the total assets in decline gradually
throughout past 20 years, causing negative consequences for economic output.
As banks
main profit margin is derived from securitisation of loans, they failed to
devote adequate attention to prudential underwriting (credit risk assessments)
of individual loans. It looks like capital requirements, which are based on
risk-weighted assets could contribute to further incentives for financial
engineers to bypass the regulatory requirements.
