Regulations that aim to increase understanding of risks for management, investors and the general public are effective, self-reinforcing and are likely to change emergent behaviour. Market wide stress testing initiatives have been particularly powerful in this regard – by requiring banks to consider explicitly the worst scenarios and publish the outcomes, the market has been driven to protect and plan for those events.
By contrast, regulatory interventions which simply represent a knee-jerk reaction to minimise aspects of the market that are troubling, are likely to have unintended side effects. For example the accounting rules to be introduced in 2018 that cover reporting of credit losses in banks financial statements (IFRS 9) have the explicit objective of recognising a banks’ losses more fully and earlier in the economic cycle. This is predicated on the idea that on average the market can forecast the next recession, or indeed the green shoots of recovery.
Unfortunately economic models are much more useful to understand the past and present than forecast the future – as a result the side effects of the new IFRS 9 regulations in practice will be to increase banks’ recognised losses in the early phases of a recession and thereby potentially increase the likelihood of bank failure.
To counteract this, banks will need to be more conservative in their lending in economically sensitive segments (e.g. small businesses and mortgage lending) as this could reduce efficiency and act as a drag to the financial services and the economy in general.