Learning Objectives:

  • Explain the rationale for banking regulation and its core objectives.

  • Trace the evolution of banking regulation from Basel I to Basel IV.

  • Distinguish between prudential and conduct regulation.

1.1 The Rationale for Banking Regulation

Banks are heavily regulated due to their critical role in the economy and the unique risks they pose. The rationale for banking regulation is grounded in several key principles:

  • Systemic Risk: The financial system is closely inter-linked. Failure of one firm often affects other firms, and the entire financial system is affected .

  • Information Asymmetry: Financial services cannot be tested at the time of purchase since there is a time-lag between the purchase and its actual effect .

  • Moral Hazard: In a competitive market with thin spreads, firms often take high risk to maximise return, making them more susceptible to default .

  • Consumer Protection: Financial services consumers are often less informed than providers, requiring protection from malpractice, fraud, and collapse .

1.2 Core Objectives of Banking Regulation

The primary objectives of banking regulation include:

  • Systemic Stability: Preventing the failure of individual institutions from triggering a broader crisis .

  • Protection of Depositors and Investors: Safeguarding the funds and assets entrusted to financial institutions .

  • Market Efficiency: Ensuring the integrity and efficiency of financial markets .

  • Consumer Protection: Ensuring fair treatment of customers and preventing mis-selling .

  • Financial Inclusion: Ensuring access to financial services for all segments of society.

1.3 The Evolution of Banking Regulation: Basel I to Basel IV

The Basel Accords, developed by the Basel Committee on Banking Supervision (BCBS), are the primary international regulatory framework for banks . The Basel standards apply to both EU and US jurisdictions, though implementation varies .

Basel I (1988): Focused primarily on credit risk, introducing a simple risk-weighting system for assets .

Basel II (2004): Introduced a three-pillar framework covering minimum capital requirements, supervisory review, and market discipline .

Basel III (2010–2017): Developed in response to the 2008 financial crisis, Basel III strengthened capital and liquidity requirements . Key components include:

  • Capital Requirements: Increased minimum capital requirements and introduced a capital conservation buffer .

  • Leverage Ratio: A non-risk-based leverage ratio was introduced as a supplement to risk-based capital measures .

  • Liquidity Standards: Two key liquidity ratios were established: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) .

Basel IV (2017 Reform, phased implementation): The term “Basel IV” is used in the banking industry to refer to the regulatory reforms introduced in December 2017 . Key components include:

  • Revised Standardized Approaches: To improve risk sensitivity, a standardised approach to credit risk, operational risk, market risk, and credit valuation adjustments has been developed .

  • Constraints on Internal Models: The use of internal models is limited by the introduction of an output floor ensuring banks’ capital is not less than 72.5% of the amount required under the standardised approach .

  • Implementation: Originally scheduled for 2022, implementation has been delayed. It is currently scheduled to enter into force on July 1, 2025, with a three-year phase-in period .

1.4 Prudential vs. Conduct Regulation

Banking regulation is often divided into two main categories:

  • Prudential Regulation: Focuses on the safety and soundness of financial institutions. This includes capital adequacy, liquidity management, and risk management requirements. The Basel Accords are a form of prudential regulation .

  • Conduct Regulation: Focuses on the fair treatment of customers and the integrity of financial markets. This includes consumer protection rules, transparency requirements, and prohibitions on market abuse .

 

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