Pic By RAZAK GHAZALI

BANKING is one of the most heavily supervised and regulated industries. Yet, banking failures always seem to catch regulators and depositors by surprise. Why is this the case?

A recent International Monetary Fund’s (IMF) study argues that the disconnect may be due to regulators looking at the wrong ratios. The regulatory ratios, the study argues, are by definition stale, backward looking and ones that are complex and have been computed based on a large number of estimated parameters.

For example, the Tier 1 capital ratio — a commonly used regulatory indicator that uses risk-weighted assets — requires not only a huge number of computations, but also parameter inputs that are estimates.

Critics like Andrew Haldane of the Bank of England argue that the complexity not only increases opacity, but the subjectivity involved renders it no better than a coin toss in predicting bank failures.

Banking regulation revolves largely around the three pillars of the Basel framework. Bank supervisors are supposed to evaluate banks based on the CAMELS framework — an acronym for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk.

Since many parts of this assessment are subjective, there is a tendency to focus on the numerically derived ratios, in particular the Tier 1 capital ratio.

Such a focus may be inherently flawed since the ratio is computed infrequently, quarterly at best, is backward looking and often plagued by issues of accounting treatment.

Rendering suspects its use as an early warning signal. No surprise, therefore, that the Royal Bank of Scotland supposedly had the second-highest Tier 1 ratio of the UK’s top banks until just before needing a bailout.

The IMF study cites several other cases where the regulatory ratios were simply too late to be of any use. In overcoming the inadequacy, this and several previous studies suggest the use of equity market indicators of solvency together with the regulatory ratios in assessing bank stability.

Several market-derived indicators like the yield of a bank’s outstanding bonds or the spread of its credit default swaps (CDS) could be of use.

Some argue equity market indicators are superior to debt market ones, largely because equity markets are more liquid and more efficient at processing new information than other markets.

The presence of equity analysts and other researchers, who closely monitor listed firms, ensure equity prices quickly adjust to new information.

Equity prices are forward looking with expectations built-in, thereby enhancing their currency and relevance as indicators of solvency.

Using a sample of 220 listed banks across the world, one research paper examined the relative efficacy of the regulatory Tier 1 ratio against several market- derived ratios like the market capitalisation ratio, leverage ratio, implied volatility and CDS spreads in predicting bank distress.

When tested for the period just prior to the global financial crisis of 2008-09, the Tier 1 ratio performed poorly, confirming Haldane’s argument that they may be no better than a coin toss.

By contrast, the best predictability came from the market-based ratios. The best and cleanest was the market capitalisation ratio. The results were consistent even in the post-crisis period.

These findings have huge implications for banking regulators and policymakers of the Muslim world. Given the generally underdeveloped capital markets and infantile equity markets, the central banks of these countries may be missing a key lever of banking supervision and regulation.

If market-based ratios are wonderful predictors of banking fragility, the underlying assumption is well functioning markets. Unless equity markets are efficient and functioning smoothly, market-based ratios cannot be meaningful.

For this to happen, several requisites have to be met. First, banks must all be publicly listed and equity markets have to be highly liquid, offering the depth and breadth needed by the diverse range of participants.

Good governance of the listed entities needs to be ensured through regulation that compels adequate timely disclosure. Rule of law and its fair enforcement needs to be paramount.

Holding management accountable to the various stakeholders is a necessity. Since equity markets are an intermediary just like banks, faith and confidence in them are important.

While the regulatory framework and ratios are intended to instil this confidence, the experience with past bank failures has shown there can never be enough regulation to make a very brittle system supple enough to withstand shocks.

The Basel banking framework has evolved with each systemic banking crisis and the current version, Basel III, was born out of the inadequacies exposed by the last subprime induced global financial crisis.

If full proof regulation is never going to be possible, then there is everything to be gained in developing equity markets that hold the promise of providing highly efficient early warning indicators.

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Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in  Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.