Chained but untamed

THE NEAR-COLLAPSE of the world's banking system two-and-a-half years ago has prompted a fundamental reassessment of the industry. Perhaps the biggest casualty of the crisis has been the idea that financial markets are inherently self-correcting and best left to their own devices. After decades of deregulation in most rich countries, finance is entering a new age of reregulation. This special report will focus on these regulatory changes, which will be the main determinant of the banks' profitability over the next few years.

Start with the additional capital that banks around the world will have to hold. Bigger capital cushions will make the system somewhat safer, but they may also reduce banks' profitability by as much as a third. In addition, they may push up borrowing costs and slow economic growth. Worse, higher capital requirements for banks may drive risk into the darker corners of financial markets where it may cause even greater harm.

Supervisors and regulators almost everywhere are still trying to find ways to deal with banks that have become too big or too interconnected to be allowed to fail. If anything, the crisis has exacerbated this problem. Some of those banks have become even bigger or more interconnected. And governments made good on the implicit guarantees offered to banks, encouraging them to take even bigger risks.

In America the rules to implement the Dodd-Frank act are beginning to take shape. Passed last year, the law runs to 2,319 pages, but it is little more than a statement of intent. Before it can take effect, 11 different agencies have to write the detailed regulations. These will redefine much of the industry in America and around the world, reversing decades of deregulation in finance in the world's biggest economy.

One key provision is the separation of investment banking from commercial banking, known as the Volcker rule. It will restore some elements of the Depression-era regulatory regime that was meant to ensure that commercial banks did not “speculate” with protected deposits by forbidding them from trading securities. Other regulations in America will set the fees that some of the world's biggest retail banks can charge when one of their customers swipes a debit card. These make no pretence to making banking safer, but reflect politicians' anger at banks and suspicions of those who run them.

Britain, for long the most enthusiastic champion of financial deregulation, is going further still, pondering whether banks' retail arms should be so tightly regulated that they become little more than public utilities. Mervyn King, the governor of the Bank of England, in a recent speech in New York wondered aloud whether the use of deposits to fund loans should be outlawed. In essence, he was questioning a basic building block of modern banking. In April a government-appointed commission said that Britain's banks should wall off their retail arms so they could be salvaged if the rest of the business were to collapse. It is also trying to devise resolution regimes and living wills to reduce the harm done when banks collapse, and it wants more competition in retail banking.

Britain is not alone in reacting strongly. Switzerland, which grew rich as its buccaneering international banks sailed the tides of capital flowing around the world, is now downsizing its global banking ambitions. It plans to impose such strict capital standards on its biggest banks that their investment-banking arms will be forced to shrink or leave the country.

The wave of new regulation comes as many banks are still struggling to regain their footing after the crisis. Across much of Europe, bad debts held by banks are impairing the balance-sheets of their governments. Ireland and Spain are trying to convince bondholders that they can and will repay their national debts, despite the losses incurred by their bankers. Doubts about those two countries' creditworthiness, as well as that of Greece and Portugal, are spreading across the continent's banks, raising borrowing costs and unsettling markets everywhere.

In America big banks are healthier, having largely rebuilt their balance sheets. Yet not all have recovered. The country's smaller regional and community banks include some 800 troubled institutions at risk of being seized by regulators if their capital ratios fall. In both America and Britain households are deeply indebted. For banks, growth in these markets, as across much of the rest of the rich world, is likely to be slow. In Japan banks are well into their second decade of a slow-motion crisis, while in China officials fret that banks are growing too quickly.

There is much that regulators around the world are doing well, yet many of their actions have been piecemeal. As a result, they tend to shuffle risk around from one country to the next instead of reducing it across the global financial system. In some ways they have exacerbated the dangers. Dodd-Frank, in its zeal to prevent any more taxpayer-funded bank bail-outs, has curbed the Federal Reserve's ability to provide cash to banks that are fundamentally sound but suffering a shortage of liquidity. That has made it harder for the central bank to act as a lender of last resort, a principle of central banking established almost 140 years ago by Walter Bagehot, a former editor of this newspaper.

The unwelcome consequences of some of the other new rules now being introduced may be greater yet. For example, the European Commission's decision to regulate bankers' bonuses in a bid to limit risk-taking may have the perverse effect of driving up banks' costs and making their earnings more volatile.

The bright spots

Banks in emerging markets face different and far more exciting challenges. They need to grow quickly enough to keep pace with economies racing ahead at breakneck speed and to reach the legions of potential customers in villages and slums who are hungry for banking. Rapid growth and the spread of computing and communications technologies have turned these markets into huge laboratories of innovation. This special report will argue that banks in countries such as India and Kenya have much to teach those in the rich world. These lessons could come in handy, for the torrent of reregulation in developed countries will soon be raising banks' costs, trimming their profits and forcing some of their customers to look for cheaper banking services.

Listen to an interview with the author of this special report