The results of the much awaited stress tests of the US banking system, announced last week, evoked a range of reactions. To those who saw this as a legitimate exercise in evaluating the system’s ability to withstand extreme shocks, the news that only about $75 billion of new capital was needed to provide the protection required came as a relief. On the other hand, sceptics questioned the rigour of the tests and the reassurance that the results provided, insisting that the problems and vulnerabilities were far greater. On the strength of the test results, various banks have already initiated measures to raise new capital. The debate on whether this will be enough will undoubtedly continue, only to be resolved when the extreme shock actually hits. Meanwhile, the exercise itself and the actions that it has induced by the banks represent another important building block in the post-crisis regulatory regime that is falling into place. This regime has three significant components as far as banks are concerned. One,the range of activities which banks can engage in will become more circumscribed. The transition of the two investment banks left standing, Morgan Stanley and Goldman Sachs, to bank holding companies reflects the compulsion that financial intermediaries face to subject themselves to constraints on how they raise funds and how they lend them out. Two, the organisational structures, particularly with respect to internal incentive and penalty mechanisms, will be substantially rebalanced. Performance evaluations will now acquire a longer time dimension, with extended accountability and deferred rewards for lending and investment decisions rather than year-end bonuses. The stress tests provide the basis for the third component, which is enough capital to protect against even extreme situations.
The combination of these three elements will certainly make banking a far safer business, with much less prospect of it being able to precipitate a global economic crisis. But, it will also make it less profitable and rewarding, which will affect the interests of both shareholders and managers. The balance of incentives will shift from innovation to caution. These developments should come as no surprise. Regulators tend to react strongly to perceived causes of crisis, even at the risk of excess. The desire being expressed by several American banks, which received funds under the Tarp rescue programme to pay back the government so as to free themselves from the many conditions of Tarp, is a clear indication of what the industry thinks of the emerging regime. But, it would be a mistake to assume that disengagement from the programme is the end of the road for regulatory change. New boundaries with respect to intermediation activities, incentive schemes and capital requirements will be imposed, regardless of what the industry thinks. Only the final contours of the new regime are uncertain and banks have a role in influencing them. The emerging shape of the regulatory regime will have global implications as well. The ability of banking systems in other countries, particularly the emerging economies, to tap into overseas funds will be influenced by their own movement towards new regulatory standards. From this perspective, financial systems worldwide are interested parties in what is happening in the US. Full convergence may remain an elusive goal but, sooner or later, all countries will have to begin moving down the same road. A domestic debate in India on the three components is inevitable.
