1/8/13 – Financial Regulation and Why It Matters

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 8, 2013 10:05:22 AM

and tagged Market Updates

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Over the past couple of weeks, significant progress in financial regulation has been made at both the U.S. and international levels, and most people don’t care. (Nor should they, in many ways.) Yet, there have been a couple of developments that are relevant to the average person.

First, though, let’s look at a broad picture of why banks matter. If the country had to operate with each individual or business using its own assets, growth would be very limited. Banks (or other lending institutions, but let’s keep it simple) allow those with extra capital to provide it, for a fee, to those who need the capital and are willing and able to pay for it. The bank acts as an intermediary and takes its own fees. Everyone benefits: the depositor, who gets paid; the borrower, who gets access to capital; and the bank, which also gets paid.

If banks don’t lend, they don’t make money—which most of us have no problem with—but the depositor and borrower also lose out. Since these people might be us, or those who create jobs, that’s a problem for society as a whole.

Because of the way banks work, they can lend a multiple of what they have on deposit. While this encourages growth, it does potentially put the banks at risk. As we have seen, banks have a tendency to over-expand during the good times. The purpose of financial regulations is to limit the amount of trouble they can get themselves into.

On that note, today’s papers are reporting on $20 billion in fines paid by banks—chiefly Bank of America—to absolve themselves of past mistakes in the mortgage market. In conjunction with the banks’ attempt to clean up the bad stuff from the past, the new Consumer Financial Protection Bureau is set to issue rules this week that will define which loans can be offered, under what terms, and to whom. The net result will be a lending industry that has largely paid for its past sins and now knows what can be done with much greater certainty.

The reasonable hope is that banks will pick up mortgage lending again. Despite the housing recovery, mortgages are still relatively difficult to get, and this new sense of regulatory certainty may go some way toward solving that problem, possibly leading to more lending going forward.

Also providing more support for lending is the recent decision to delay implementation of the full capital requirements under the new Basel III banking regulations. In brief, banks now have an additional four years from the original 2015 deadline to build up a larger capital cushion, and they have more options about what can count as part of it. This is a loosening of the regulations, but it makes sense. Under the previous timeline, banks would have been forced to cut back lending from already weak levels. By keeping the requirement but extending the date, that won’t happen—again, a positive for the economy.

Overall, regulations should be designed to prevent trouble, not create it. It’s nice to see that, recently, the banks and the regulators are acting with that in mind.

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