EU banking regulation has created an inefficient financial system

From the reader. Editorial over-regulation of banks (KL 15.1.) and OP Pohjolan director general Timo Ritakallion previous talks about domestic reduction of bank regulation are apt. However, the problem is also related to EU banking regulation, which slows down structural change and productivity growth.

After the financial crisis, EU banking regulation has improved the stability of the financial system, but weakened its ability to allocate capital. The basic role of the financial system is to transfer funds from surplus actors to deficit actors, especially investing and growing companies. In Europe, this task has traditionally been handled by banks.

After the financial crisis, the EU tightened banking regulation. The key reforms were the introduction of the Basel III regulation as a regulation of banks’ solvency and solvency, as well as the tightening of capital requirements, liquidity rules, risk-weighted capital requirements and stress tests.

Why did the heaviest burden fall on commercial banks?

The goal was to reduce the risk of banking crises and the responsibility of taxpayers. The central problems of the financial crisis were related to securitization, the repo market, investment banking and the shadow banking system, not traditional corporate financing. Despite this, the heaviest burden of regulation was placed on commercial banks.

Regulation weakens capital allocation through several channels. First, risk weights distort lending, as corporate loans, especially SMEs, are assigned high risk weights, while government debt often has a zero risk weight. It is rational for the bank to invest in government debt instead of financing investments, which diverts capital away from productive private activity.

Second, tighter capital requirements make lending expensive, because a new loan requires more equity. This lowers the marginal return on lending and especially weakens the financing of long-term and risky investments, which is why innovative and growing companies are often left without financing.

Stable, but ineffective

Third, liquidity requirements favor short-term and safe investments. Liquidity rules encourage banks to hold easily realizable and low-risk instruments and penalize long-term corporate financing. This weakens the financing of investments and the banks’ ability to perform their core tasks.

Fourth, regulation increases banks’ prudence. Stress tests and threats to reputation and sanctions can lead to banks reducing lending to small businesses and start-ups. This weakens the flow of capital between deficit and surplus actors.

The end result is a stable but ineffective system, where EU banking regulation reduces crisis risks, but at the same time weakens the financing of investments and slows down structural change and productivity growth. Bank regulation must be deregulated so that the banking system can once again allocate savings to companies that make productive investments.