There has been a race between banks and regulators to add size and complexity to banking groups on the one hand and to regulations that cover such businesses on the other. It is questionable that smaller and simpler banks and their clients are best served by this development. At the same time, the financial system suffers due to a lack of diversely set up banks, with varied types of loans and interest rates on offer and with business models that are not prone to fail at exactly the same time.

If only it were possible to say in advance which banks will be dangerous in the future. In that case the solution would be simply to abolish most rules for the non-dangerous type. Crystal balls are in short supply, however, and time after time, both big and small banks have surprised regulators by being unpredictably safe, or unsafe, and if unsafe, by suddenly being systemically important (or politically important) at their point of failure. Legislators and supervisors do not like such surprises, and have responded by adding ever more detail to the Basel (and EU) capital framework and the Basel core principles for banking supervision. The original framework was drafted at a time when the ‘big, diversified and internationally active banks’ for which it was written were of the size that small banks are now, and capital markets and markets in financial instruments were relatively simple. Open borders in the EU single market (and around the world for some financial services) have since allowed a consolidation wave between banks operating in ever larger, more complex and interlinked financial markets, for which the original rules no longer appeared to suffice. This consolidation is then reinforced by the need for size to absorb the costs of stricter rules, and in times of crisis by supervisors begging relatively stable banks to take over relatively wobbly banks.

So now we appear to be stuck in a set of complex rules designed for complex banks and complex financial systems. And strangely, in many submarkets such bigger banks are behaving in exactly the same manner, dropping small borrowers as reviewing and monitoring them is too complex, dropping trade finance and USA linked clients because there are too high AML or FATCA administrative burdens associated with them, targeting exactly the same profitable and asset rich clients to offer loans to, and offering depositors the same tawdry deals because for large banks the wholesale funding market is both simpler, more predictable and cheaper than managing a plenitude of surly savers. Especially if having such depositors means higher fees to be paid to deposit guarantee funds, resolution funds, supervisors fees, and likely to local tax authorities.

The traditional EU approach to the capital framework has been that all banks should be on the same level playing field, and that the so-called proportionality principle will provide for enough flexibility to allow smaller and simpler banks to thrive. But how to apply the rules proportionally, when it is not clear for smaller banks that their supervisors will accept anything less than perfection, and for supervisors that leeway granted to their banks will not come back to haunt them when that bank fails? There is no safe haven for either banks and supervisors to hide from liability or bad publicity if something goes wrong that could have been prevented if rules to calculate requirements or set up a check and balances system could have been enforced too.

Now, it could be defended that the complex rules serve a useful purpose for complex banks. Their business is driven by a need to reduce regulatory capital requirements, and to prevent innovative abuse or avoidance the regulators have to be equally innovative to think up new detailed rules or guidance. In the absence of minimum capital requirements their sheer size otherwise might mean that in the eyes of the financial markets they can get away with even more minimal safety measures as long as they appear to be profitable. This is not the case for relatively smaller banks, where the amount of capital needed to be able to attract wholesale funding is often higher than the amount of regulatory capital required under solvency ratio calculations. For these smaller banks, the absolute number of regulatory capital requirements is not so much the burden, but the sheer size of administrative and reporting measures that are needed to be able to calculate this via the solvency ratio. And this burden is difficult to make proportional to their business, as the main elements that support that calculation need to be present in the same manner in both big and small banks to be able to come to a trustworthy outcome of standardised or internal models on which the solvency ratio is based.

Creating a lot of lightly regulated shadow-competitors for banks (such as via e-money, payment institutions, venture capital or social investment fund rules) does not solve the fact that the traditional basis of banking, attracting deposits, making loans, providing facilities, and thus easing the functioning of the economy, is becoming the prerogative of ever larger organisations that can optimize the regulatory burden of solvency ratio calculations.

If regulators and the remaining smaller and simpler banks are truly interested in more competition between banks, more choice for clients (both lenders and borrowers), more diversity in the banking sector, more effective rules, or at least less complex rules, then substantial changes in the prudential regime should be considered. Though it is easy to be married to the status quo of the Basel capital accord, it should be remembered that it is a relatively young framework of barely 40 or 50 years of age, that has been growing organically, and was never intended for the simplest banks, but for the most systemic banks of its day and age. And there are alternatives that still are based on available experience in the way banking was structured in the past, or how it is structured for state licensed banks in the USA, or how supervision is structured in the insurance sector.

In order to be contemplated by regulators, however, any alternative regime will need to be more effective than the current regime in preventing harmful fallout of a banks’ failure. Though the existing set of complex rules has a dismal track record during various crisis, there is a belief (though that belief possibly only exists in press releases) that the various untested add-ons of the last few years will work better in limiting the potential for future crisis. This even though for instance the much admired bail-in instrument has the potential to cause contagion in the bailed-in creditors, and harsher market risk requirements risk reducing the liquidity of markets in certain financial instruments. While waiting for the jury report on the effectiveness of the new add-ons to arrive during the next crisis, that belief in their sturdiness is a political reality. If an alternative simpler regime is even to be contemplated, the alternative simpler banks subject to it should thus be even more ‘safe’. Preferably, any legislator and supervisor that replaces part of the current regime for a simpler alternative should be able to honestly say that they do not care to have e.g. full control and complex data over the bank, because the public interest is fully managed in another way. In my opinion, this other way could be found by making the failure of such simple alternative banks irrelevant for the protection of their clients, and irrelevant to the financial system in which they operate. This will only work if the banks’ full failure hurts no one except the bank itself and its equity providers, not even if similar or related banks would fail at the same time. So if we would like more diversity in the banking sector, and allow some banks to compete on different conditions without undermining safety nor a level playing field, a new balance would need to be struck by deleting the most onerous obligations of the current regime for simple alternative banks, and replacing them with equally safety enhancing but more simple alternative measures.

Smaller and simpler banks appear to suffer most from the calculation, supporting organisational requirements, and pillar 3 and regulatory reporting requirements that relate to the solvency ratio. For non-complex banks, as indicated above, these requirements actually do not even result in a credible minimum capital level in the opinion of the banks themselves and/or the markets (small banks operate at higher capital levels than the minimum required). These solvency ratio calculations thus appear to be surplus to annual accounting calculations. While these regulatory requirements do not bind them, they still induce costs and force banks into specific business models. But ditching the solvency ratio requirements and all adherent organisation and reporting burdens, would be a large shift from the current regime, and would force supervisors out of their comfort zone. Even when the results of imposing the solvency ratio are thus far underwhelming and their limitations badly understood; their usefulness as one of the few means of control and – even if ex post – verification is at the moment not paralleled by other measures.

Nevertheless, I would propose deleting the solvency ratio calculation and all supporting requirements in full for a subset of simple alternative banks, subject to a range of conditions. Any tinkering with the solvency ratio – which evidently is in the comfort zone of regulators and supervisors – would not result in a measurable reduction in burdens, while only adding to the small forest of trees cut down to be able to print the so-called single rulebook now. The conditions for escaping the solvency ratio obligations should be simple and at the same time compensate for its loss, and prevent abuse. They should thus include the majority of the following:

• Personal liability of all current and (recent) past members of management and anyone ‘owning’ or ‘controlling’ the bank e.g. by having a stake of more than 10% of equity. Introducing collective responsibility in this manner would make banks again more similar to the out of fashion partnership-based banks, and force key influencers to face up to potential negative consequences of their or their partners’ decisions. An alternative could be a non-profit bank with mandatory low salaries and a prohibition on dividends and bonuses, but this would require some talented people to be willing to work for a fraction of their commercial salary solely for idealistic reasons.
• A leverage ratio based solely on comparing existing annual account information set at a high number (e.g. 10% or more, to be calibrated at the high capital levels smaller banks now have), combined with an FDIC style prompt corrective action tool. This could be supplemented by other indicators of health, but only if those are based on already available public annual accounts data.
• Limiting the asset side of the bank, by reintroducing the habit to issue limited banking licenses. For instance licensing such banks to be focused on SME finance, or on trade finance, or on infrastructure investing, or on mortgage loans. This is still an existing feature in the insurance sector, where the main type of insurance written by any specific licensed entity has to quite similar, e.g. limited to car insurance, or to fire insurance. Apart from their specialisation on the asset side, their business should only consist of deposit taking and offering payment accounts. This would clarify their transformation function, and ensure that their management can be focused on a specific business.
• General demands on management, valuation and bookkeeping sufficient for annual accounts and conduct of business purposes could remain in place.
• No deposits or credits should be accepted that are not fully guaranteed by a public deposit guarantee fund; or that are fully collateralized/insured by repo’s, covered bonds, credit default swaps or by other credit insurance. It could be contemplated to prescribe that a proportion of the deposits should be term deposits, though any simple alternative bank with a personally liable management is certain to keep a good liquidity buffer if they have immediately redeemable deposits.
• The maximum market share of such simple alternative banks in each specified banking activity they can be active in under their licenses, should be set at a level that ensures that both the deposit guarantee fund and the financial system could relatively easily absorb the net losses that will be suffered due to their potential for – even collective – failure (in a more strict version of the USA concentration limits).
• Such a bank should have all its activities within the same legal entity. It should be prohibited from having subsidiaries, should not be allowed to make loans to group entities, and should only be allowed to outsource to non-related entities that would not fail in case of its failure. If it is part of a group (e.g. a automotive group, or even a financial group), such a license can only be issued to one simple alternative bank per group. It should be supervised solely on a solo and stand-alone basis, and the parent group should be ignored except as an ex-post suable party in case of the demise of the bank. The equity share in a alternative simple bank by any ‘normal’ parent bank should be weighed solely as a capital investment both for solo and consolidated supervision purposes on its parent bank (to avoid solvency ratio requirements landing indirectly at the alternative simple bank).
• Instead of a supplementary pillar 2 regime, it should have a stand-alone annual obligation to write a business plan with its main business options and risks, and what it plans to do on both accounts.
• Its resolution plan should be simple: full liquidation, repaying the deposit guarantee fund for protecting its depositors, combined with the liquidator maximising the size of the estate by suing the liable persons within its structure for any deficit in repaying the DGS and other (collateralized) creditors.
• They should be identified by a separate name that highlights frailty (bank light, mini bank, high risk bank, or even alternative simple bank).

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If the bank or its equity providers want to abandon these restrictions, they can of course opt into the solvency ratio regime, perhaps with even the liability for new obligations incurred after the transfer slowly tapering off (though some form of collective liability of all key influencers would be good at any bank). For new start ups, this would have the benefit that by the time they would like to do so, they have had the chance to build up both their organisation and their expertise up to the required level to be able to work in that more complex environment. During a try-out phase for this new regime, it could be envisaged that such alternative simple banks should not operate on a cross border basis. Anything longer than during a try-out period would, however, irreparably damage the concept of the EU single market.

Whether such a regime-change is credible remains to be seen. It is out of the comfort zone of EU and Basel regulators (no more solvency ratio?) and latter day bankers (liability?). If banks and regulators are indeed serious in their concerns about the current regime and its impact on the way the banking sector performs its functions to the benefit of all of us, it should nonetheless be considered.

Also see:

Are EU Banks Safe?

Actal advice to the Dutch Minister of finance, Regulatory burdens on credit, 23 July 2015, plus the accompanying EY report of May 2015 (both in Dutch)

CEBS, results of the comprehensive quantitative impact study, 16 December 2010, www.eba.europa.eu. Also see BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, August 2010, www.bis.org.

The debate on whether insurers can be systemically important has taken a strange turn. After focusing on non-traditional and non-insurance activities at large international insurance groups, the scrutiny is now on whether or not to include reinsurance groups into the set of systemically important insurers. Lobbyists are rumored to have found the weakest link at the FSB (this time the USA) to stop reinsurers from being considered as systemically important. The arguments for this remain unclear. The main reinsurers are big, their clients depend on them, and if they have to liquidate their assets to afford a timely payout this would impact on the financial markets.

In the past, arguments appeared to focus on the expectation that the problems would be dampened by the structure of the insurance market. A regular insurer stands between them and policyholders, which would continue to be liable even if the reinsurer on which it relied fails. A traditional argument is also that reinsurance is more like traditional direct insurance instead of like non-traditional insurance activities such as derivatives investing. If such reasoning would be considered valid still, that would be shortsighted, but not unexpected. Reinsurers, insurers and the IAIS have a track record of downplaying potential contagion arising in the insurance sector, including in the reinsurance sector.

Reinsurers are not client-facing, that is true. And the policies they close are not structured as formal derivatives, but as insurance policies of a direct insurer against the materialization of a risk (in their case, that policyholders make claims at the direct insurer). If a reinsurer fails, the direct insurer is indeed left holding the bag. However, that direct insurer would have a huge gap in its capital and technical provisions. A reinsurance contract counts as risk mitigation for prudential supervision purposes at the direct insurer. If the reinsurer can pay out, it does indeed mitigate that risk by offering to pay all or part of the claim that arises from a policy written by a direct insurer (in exactly the way derivatives do if the triggering event occurs). The direct insurer subsequently does not need to hold financial buffers for potential claims that are no longer expected to land on its balance sheet as it is expected to be reimbursed in full by the reinsurer. For large reinsurers this (large) gap at the direct insurer it contracts with is multiplied across all the direct insurers it accepted premiums from. If one of them makes a disproportionally large claim, the reinsurer may no longer be able to honor its commitments to other direct insurers, making reinsurers the main potential channel for contagion in the insurance sector. As e.g. mortgage loans are built on required fire insurance and long-term pension payments from life insurance policies, this would impact on the banking sector too, providing another channel for systemic risks. Even if reinsurers can delay the pay-out by denying the validity of claims, that would just speed up the problems at the direct insurers and their clients, and would not dampen market expectations of asset sales by the reinsurer for an eventual pay-out.

The limited set of large reinsurers are thus a crucial underpinning of this sector of the financial market, similar to the role of central clearing parties (CCP) in securities trading, and ECB systems in Eurozone payment systems. The argument a non-client-facing entity is not systemic has been (and should be) eradicated from public policy thinking since the AIG London branch, LTCM and the Fannie Mae/Freddy Mac bail-outs. Even shareholders of large reinsurance companies like the subsidiaries of Berkshire Hathaway should actually see the benefit of better focus on and the acknowledgement of the importance of such key service providers. For one, it makes their investment in a reinsurance company less likely to suffer catastrophic damage. And if reinsurance would get a more explicit systemic role as a stimulated safety buffer for the wider insurance sector (like CCP’s and depositaries are for the securities markets), it would actually be a business opportunity. It would strengthen their hand against competitors from the hedge fund industry or (other) derivative writers. Even so, it would be more likely that shareholders and boards of reinsurance companies would actually admit that reinsurance is systemic, if the consequences of being deemed systemic were more focused on the business at hand. This is now not the case. The FSB and the committees that work for it (such as the IAIS) appear focused on just slapping an extra percentage on a yet to be developed solvency ratio for large worldwide operating insurers, in a move copied from the banking sector. The fact that it is not yet tested there as an effective tool to avoid or even mitigate a banking crisis does not seem to dampen regulatory ardor to roll it out to non-banks, but it may dampen the ardor of shareholders and boards to subject their reinsurance companies to it.

They have a point. To me it appears strange that the systemic surcharge on top of a debatable ratio calculation is now copied in other financial sectors as if it is a wonder formula. Especially if there is little or no experience with a solvency ratio in the insurance sector in the first place (where a first solvency ratio under the EU Solvency II directive is being rolled out only now). It is not guaranteed that a higher percentage for systemic insurers based on a totally new formula for calculating a ratio would withstand (fear of) the potential waves of destruction of a next crisis, nor that it would avoid the pitfall of being calibrated to the last crisis instead of to the next.

It may be better for the FSB and the (re)insurance industry instead to come up with a more measured response, focused on what is known to work in the specific financial sector at hand. For instance, CCP’s have a similar role in the securities sector both as a core service provider, risk mitigator for client facing securities firms, and – because they are trusted to handle this – risk aggregator as reinsurers have in the insurance sector. CCP’s developed homegrown techniques to be able to bear that risk, mainly by a system of collateral (margin), guarantee funds and novation and netting through which risk is minimized and spread. If reinsurers de facto are relied on in the insurance sector to play a risk-mitigating role and want to be trusted to be a risk aggregator, they should equally develop or expand risk-mitigating techniques. If reinsurers ask legislators to rely on the insurance they provide to direct insurers – which does appear to be part of their business model – they could embrace this role in a proactive manner by mitigating such aggregation/concentration risks. It should not be necessary to assume that each can withstand a multiple of risks arising at the same time, it should be certain. In other words: if reinsurers would like policyholders, direct insurers and supervisors to embrace a core role of reinsurers, it becomes more important that they are bankruptcy remote.

Learning from the CCP example and from what has worked well in the insurance sector, it might be good to take a second look at the benefits of solo supervision and the assets reserved for the calculated technical provisions (i.e. the calculated maximum potential pay-out under open policies). Instead of relying on untested new solvency ratios – even if they are calibrated to be higher for systemic entities – a better response to a systemic reality would be to rely on a combination of:

• more conservatively calculated technical provisions for the maximum potential pay-outs under the reinsurance contracts they have written;
• segregated assets for those;
• collateral rights held by the collective of (policy holding) direct insurers on those segregated assets;
• with a clear pay-out schedule that guarantees equal treatment of various current and future claims;
• and perhaps a mutual guarantee system if overwhelming claims arrive at a reinsurer.

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Also see:

• Buffett clout brought to bear in rules fight, FT 14 October 2015 (published under different title on ft.com on 13 October 2015).
• EU Banking Supervision, chapter 6.2, 6.5, 19.4 and 22.
• Are EU Banks Safe?, chapter 4.5.
• FSB, 2014 update of list of global systemically important insurers (G-SIIs), 6 November 2014.
• IAIS, Reinsurance and Financial Stability, 19 July 2012.

A new component of the recovery and resolution framework for banks is the mandatory bail-in of shareholders and unsecured creditors that will become mandatory across the EU at the latest in 2016. The bail-in of creditors has been introduced to avoid having member states (ultimately at the expense of its taxpayers) chipping in to bail out a bank that is too important for its economy to let fail. As a policy choice this is understandable, even if much of the initial investment in bailing out a failing bank is normally recouped when the bank or its assets are sold at a later point in time (unless the public sector owner manages the bank for other public policy reasons than recouping its investment).

For subsets of depositors/investors at banks the new mandatory bail-in at the behest of resolution authorities requires a new mind-set in risk management. Specifically this applies to those depositors holding funds at the bank that are not protected under the applicable depositor guarantee system, such as companies or individuals keeping more than 100.000 euro at the bank, or (from 2019) those that bought bonds issued by the bank.

The new rules aim to the public budget, while continuing to protect small depositors, and anyone with a secured claim on the bank (such as central banks). Really new in this line-up is the protection of the public budget, or as politicians/legislators name it: ‘the taxpayer’. Increasing the protection for the public budget does mean that the losses will have to be suffered by someone else, in this case the ‘senior unsecured creditors’ that used to rely on (1) implicit government support for large banks, (2) good banking supervision that would fail and liquidate the bank when it was still solvent enough to pay back each senior unsecured creditor after the liquidation process, or (3) for bondholders that qualify as consumers or small companies on the explicit deposit guarantee system for bond portfolios up to 100.000 euro. These are all in the process of being removed, as senior unsecured creditors will no longer be protected under any of them but instead will be forcibly bailed in when there are signs that the bank might be in trouble. The thinking is probably that very wealthy individuals will ultimately bear these costs, but in practice the impact is more likely to be suffered by pension funds, insurers, banks, investment funds that hold cash at the bank in their current accounts, have bonds or own shares issued by the bank, or have to replenish deposit guarantee systems that have to cough up the cash under a bail-in. And by the consumers and companies dependent on them of course.

Though the commitments to the pension fund of the employees of the failing bank are protected, any debts to other pension funds or insurance companies are fair game. Regulators can still opt – in an optional and thus non-dependable manner – to exclude bail-inable creditors at the moment of the bail-in if they for instance fear unrest. This might benefit certain senior creditors, but will only increase the burden on the remaining senior creditors that do not get this benefit from the resolution authorities (for instance because they are based in another member state, or are too small to start a crisis if they in turn fail due to writing down the money they had entrusted to the bank).

For bonds, the exclusion from deposit guarantee protection and accompanying bail-in-ability may be somewhat defendable (in spite of the potential financial instability risks of writing down bank bond values), as long as the right risk premium is paid by the bank for this risk. I understand that after downgrades of bank bonds by rating agencies in anticipation of the bail-in instrument, the (ultra low) interest rates on unsecured senior debt have shown an increase in the risk premium paid to investors in such bonds. It is doubtful whether that risk premium is enough to compensate for the de facto highly increased risk that bank supervisors will deem a bank to be potentially in trouble and potentially to cause financial instability, and ‘rescuing’ the bank by increasing its capital by writing down or converting these bonds. This can and perhaps should be judged part of normal risk management at the institutions investing in such bonds. It could be a conscious assessment by a well-trained lender that the likelihood of such an event is sufficiently low per bank in a diversified portfolio of bank bonds that even at the current low interest rates the small add-on constitutes an acceptable risk premium. Perhaps. For non-deposit protected consumers and non-financial companies that invest spare cash in bank bonds after the deposit insurance expires for bank bonds in 2019 it is unlikely to be as well prepared for.

A risk perhaps less well understood is that any cash held at any bank on a savings/payment/current account (to the extent it exceeds the coverage by the deposit guarantee system or collateral, and thus also constitutes a so-called senior unsecured credit) is subject to the same write down or conversion as unsecured bonds are. For instance, if a pension funds uses one single bank to collect the liquidity needed to make out the monthly payments to its pensioners, it is in fact making a high risk investment in the bank. This high risk materialises if the banks’ supervisor and resolution authority decide that the time for failing the bank has come before the order for the transfer to pensioners has been given. The bank will in that case re-open the next Monday as usual, but the cash needed by the pension fund to make the payment to pensioners will no longer be available as such cash was bailed-in. The supervisor/resolution authority may or may not give an exemption to the bail-in, but this would increase the burden for others (and is certainly not a right of the pension fund).

The main dependable exception is if the bank gives collateral to the owner of the cash, in the example to the pension fund. Senior unsecured debt is bail-inable, but secured debt is excluded. This is for instance the case with central bank loans that will be collateralized by sovereign bonds or other acceptable collateral. Other examples are for funds owed in the clearing and settlement process, or in the case of bonds so-called pfandbriefe and other covered bonds (that are secured by specific assets of the bank). Small pension funds and small insurers will normally not have the market power or political power to ensure such security is given to them for payment accounts. If they do not get it, they may be wise to spread their cash holdings over a wide range of banks in order to avoid potentially losing all their cash in one go. They could also seek insurance e.g. via derivatives on the potential that a bank will fail, but that may be costly, and it would need to be certain that the writer of that derivative/insurance is not itself linked to or exposed to the bank that is failing.

Should the shares in a bank, bonds issued by a bank, and savings held at a bank by an institutional investor be bailed in, this may have an impact on its own obligations to pay out. An investment fund will be worth less (and so will the pro rata investments by its investors, and the investors in such investors), which may or may not have been understood by those investing via such a fund. At an insurance company or pension fund it may mean that premiums will need to be increased, or payouts reduced. Though their clients may not always be taxpayers in the country where the bank was based, they will definitely be taxpayers somewhere. Taxpayers will thus still bear the costs directly or indirectly via their pension funds, investment funds and insurance firms. The main change is that this burden will only to a lesser extent arrive via state budgets (which will still contract due to lower tax receipt as a result of the losses suffered by banks, insurers, and individual taxpayers, as well as via bailed-in cash held by municipalities, provinces and other state bodies at the bank). The main advantage is the public relations benefit that the burden will not go via the state budget immediately, and that the costs – if pension funds, insurers etcetera have limited their risks via risk management – will be spread out over time and many consumers. Small increases in premiums or limits to payments are less noticeable than a big headline number of initial investment by the state in a traditional bailout. Saving the taxpayer by bailing taxpayers in (directly or indirectly) does, however, appear to be logically impossible.

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– Recital 1, 5, 8, 31, 67 and art 44, 47, 48, 108, 109 and 130 BRRD directive 2014/59/EU

– Recital 5 and 6 Recast Banking Directive 2006/48/EC (part of the previous version of the CRD)

– Art 27 SRB regulation 806/2014

– Art 1.1 and 1.4 of the currently applicable Deposit guarantee directive 1994/19/EC, and Recital 47 and art 5, 20 and 21 Deposit guarantee directive 2014/49/EU (of which 5.1 sub k on excluding bonds will be applicable from July 2019)

– Italy/Romanelli, EU Court of Justice 11 February 1999, Case C-366/97, §13-15.

– EU Banking Supervision, chapter 4.4, 18 and 19

– Are EU Banks Safe?, chapter 3

The VW manipulation of its emissions testing results provides lessons for banks, insurers and their supervisors. Testlab results bear no similarity to real life survival or failure is a simple one. Bad governance structures can lead to bad decisions (as highlighted by John Plender in the FT and supported by a wide range of examples such as the DSB Bank failure in the Netherlands). Another lesson is that the testlab/models that are the basis for calculating capital requirements are prone to pressure and manipulation.

There appear to have been two stages that shifted the results in response to high-level orders to pass environmental tests and improve sales. The first is the – as I understand – industry standard in the EU that emissions are only tested in laboratory conditions on vehicles that are specially selected and prepared for this testing by stripping off all inconvenient aspects (rear view mirrors, wipers, and anything that weighs anything in the car that is not needed to make it run, such as the standard airconditioning or audio equipment). For some this is the minor league of evasion or fraud as it ‘only’ changes the hardware, and anyone actually looking would notice. Even for this type of lab-adaptation there is little relation between the car in the lab and on the road, but some people would say it remains in the nudge and wink category of how smart it is to evade the vague requirements and the light touch oversight, and the general contours of the car tested remain the same. The second stage is now provoking more outrage, as the manipulation is not in the visible hardware, but in lines of code in the software. Any instrument that supposedly cleans up the emissions but was a drag on ease of handling on the road was automatically switched off by the design of the software, except when the exact conditions of the laboratory test were found.

Though it is unlikely that executives removed the hardware from the testlab-models or wrote the software that changed the car from fake circumstances to real life riding and back, it is likely that they created the incentives to do so by demanding relative growth as compared to competitors, in the cars case by simultaneously demanding low emissions during tests so that the cars could legally be sold, and high performance so that customers would actually want to buy them, and did not bother to sufficiently check whether the product sold fit the description on issues that customers did not bother to verify or sue on, and regulators did not bother to/were not able to check.

The calculation of capital requirements is open to similar pressures. It is abstract, only important if thousands of products fail to perform at the same time, only important in the long term, and customers do not like it while the bank or insurer is alive because it heightens their costs if the bank or insurer would take it seriously. The old standardised approach for capital requirements calculation was abandoned for complex institutions because the choices made in investments were optimized by these institutions to take the highest risk/reward road within each wide basket of types of assets, such as corporate bonds. This maximized returns while minimizing costly capital requirements. The newly invented ‘internal’ models that have been introduced for banks in the 2004 Basel II accord (in the EU implemented via the 2006 version of the CRD) and will be introduced for insurers in 2016 under Solvency II allow more leeway to reward the bank or insurer if they choose a less risky product to invest in, but does expect them to take better regard of the more risky products too. Some banks are indeed relatively conservative or are being forced to be relative conservative by their supervisors, and estimate the riskiness of the assets they hold higher than the models used by their competitors estimate the same or the same type of assets. Some banks, however, are removing the airconditioning and audio systems by abandoning newly capital-costly areas such as trade finance or investment banking, while plunging collectively into low capital-costly areas, or professing high confidence in their clients or risk management systems. The result is that banks’ internal models show wildly different results, which is an indicator that some may be too lightly capitalised for the risks they run in their entire business. An additional result is that worthy areas of services are no longer provided by banks, but are either not provided, or are now provided by less regulated service providers. It is likely that more conservatively calculating banks are under pressure to become more ‘capital efficient’ in order to retain profitability and competitiveness.

The temptation to adapt the outcomes of test-results is easy to understand. Lower capital requirements (emissions) lead to the potential for acquiring more assets (making more sales) that generate higher profits and higher status for the CEO. And a slight tweak in one area that makes the boss happy does not really impact a lot on the overall capital; except of course if this happens in all areas the bank or insurer is active in. These tweaks stimulate the financial company, their shareholders and the economy as long as the bank or insurer makes no losses yet. And the internal models used by complex banks do not show with a big blinking warning whether there is internal pressure to always lean in the same direction. Fundamental attitudes towards the need for buffers or the need for speed and profits are neither measured nor checked easily, especially if the number of experts is vastly larger on the bank’s side than on the supervisors’ side. But if the general attitude at a financial company is that it is acceptable to have slight manipulations, or just slightly reducing the riskiness of the asset just by removing the dragging mirrors from the test-lab model, this risks the continued survival of the firm once it comes out. Removing trade finance already does not make the bank safer. It just makes it less well capitalised, and diminishes the value of the bank to society similar to cars with high Nox emissions in real life. Especially harmful would be if it turns out that the models used by banks are deliberately built to optimise testlab results that bear no relation to known market and firm behaviour when risks materialise. Bankers/Insurers would, however, not be unique in such manipulation. The regulated bits of internal models and the standardised models are riddled with such deliberate misdesign by lawmakers, e.g. to underestimate the riskiness of SME-loans, or to hugely underestimate the riskiness of sovereign bonds. In the end, if banks add to this, and do not compensate for design-faults in the laws that rule the design of models to calculate capital by adding voluntary layers of safety themselves, it remains deceit towards clients, investors, and society as a whole.

Though supervisors are aware of the discrepancies, they have been kicking the can down the road for a while, and there are no signs yet of an official line. The amount of capital needed for the most derelict banks – and the financial stability consequences of exposing them – may pressure them into regulatory forbearance. Though this is both understandable and damnable at the same time, such regulatory forbearance does not impact on the own responsibility of bank and insurance boards on whose watch such collective leaning or manipulation takes place by underlings who aim to please their bosses by improved headline numbers.

Safety should not be tampered with, and will not be tampered with in the long run, as the sheltered executives of VW already found out.

Also see:

• Plender, John, Poor governance at VW should have been a warning to investors, FT 30 September 2015
• Noonan, Laura, ECB doubles the time needed to review banks’ risk models, FT 16 August 2015
• EBA reports of 22 July 2015 on eba.europa.eu
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013)
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013
• UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 71-73

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• EU Banking Supervision, chapter 6.3
• Are EU Banks Safe?, chapter 4.5