The financial crisis has made it abundantly clear that banks are not self-regulating institutions. Left to themselves, they took on too much risk and failed to protect themselves from unexpected events. The taxpayer had to rescue everything from AIG and Citigroup to Royal Bank of Scotland and politicians promised they would change the laws and the culture to make sure it never happened again. Now governments are struggling to work out the best way to keep their promises. Even the smartest and best-paid regulators could not examine and second guess every bank decision. Not only would the cost be prohibitive but the time involved could well kill off financial innovation. Bankers would have to be forced or persuaded to do it themselves. So politicians have rushed to pass laws such as the Dodd-Frank financial reform act in the United States and the pending Financial Services Bill in Britain. Regulators and central bankers, meanwhile, have stepped up their efforts to audit and challenge banks as part of their regular supervision process. Some have also begun coming down harder on the violations they find with higher fines and more public sanctions. But no one is quite sure what will work best. That is where research by Dr Manthos Delis, Senior Lecturer in Banking at Cass, and Panagiotis Staikouras, Assistant Professor of Law in the Department of Banking and Financial Management at the University of Piraeus, comes in. They looked at regulatory staffing levels as well as the frequency of inspections, audits and enforcement activity in 17 countries from 1998 to 2008 to see whether any of it had an impact on the amount of risk being run by the banking system in each country.

Actions, not words
Essentially they were trying to answer the question: what is more important for curbing risk - adopting new laws and policies or regulators who are willing to confront and punish banks? Their study, Supervisory Effectiveness and Bank Risk, which was published in the Review of Finance, the official journal of the European Finance Association, concludes that actions speak louder than words. In countries where regulators conducted regular audits and frequently imposed sanctions when they uncovered bad or imprudent behaviour, banks ran fewer risks than those in countries where public sanctions were less common. The authors also found that simply passing laws requiring specific behaviour did not have the same effect. Enforcement was an essential element. The authors used databases of regulatory activity in each country and compared them with the level of risk in the banking system. They found that as supervisory activity went up, risk went down. They measured risk in two different ways: they took the percentage of non-performing loans as an indicator of the credit risks the banks were running; and they divided each bank's profits and equity capital by the variance in its reported profits over several years. The bigger and more volatile the profits, the more likely it was that the bank was running large and unpredictable risks.

On-site inspections
Banks should be more tightly supervised," says Dr Delis. "The most effective way to supervise is through audits and sanctions. There is a difference between laws on the books and sanctions and audits." The study found that the more sanctions a country imposed, the less its banks were at risk. By contrast, the authors could not show that on-site inspections had a similar effect. If inspections do curb risk, the relationship is not a straight line. Higher capital requirements tended to cut bank risk as well, the authors found, but the effect was concentrated in banks operating close to the minimum allowed levels. "A credible threat of supervisory intervention appears to be the underlying driving force behind the disciplinary effect of capital requirements," the paper says. Dr Delis believes the work points the way forward for regulators seeking to prevent the next financial crisis. "Our findings suggest that regulators should place more resources into auditing and, where needed, sanctioning banks for faulty behaviour, than [into] formal rules and regulations," he says. "If anything, the new regulatory umbrella should probably be more focused not on further raising capital requirements, but on enhancing the transparency in the banking system and perhaps on separating types of banking."

Stricter supervision
Enforcement actions did not have to relate directly to risk or to a bank's safety and soundness to have an effect. "If there is another type of action, there is a spill over to bank risk because the bankers can see there are sanctions [when rules are violated]," Dr Delis said. Policymakers say that improving the standards of supervision worldwide is critical to their efforts to contain the risks inherent in global banks. The Financial Stability Board (FSB), made up of supervisors and central bankers from the largest financial centres as well as representatives of the World Bank and International Monetary Fund, recently put forward a series of reforms aimed at 29 "global systemically important financial institutions" or G-Sifis. Most of the attention has focused on the provisions requiring these banks to hold extra capital and write plans to help regulators stabilise or wind them down in case of trouble. But global regulators have been adamant that stricter supervision by international colleges of regulators is a critical part of the package. "Effective and efficient colleges are important, not only for consolidated supervision on the microprudential level but also for the promotion of financial stability," the Basel Committee on Banking Supervision wrote in a paper last year.

Insider trading
Both the FSB and the International Organization of Securities Commissions (IOSCO) have been working to promulgate standards for supervisors and to make it easier for enforcement divisions to work together across national lines to punish wrongdoing. Over time, IOSCO information sharing should lead to increased enforcement on issues such as insider trading and misleading the markets. Some national regulators clearly share Dr Delis's view that more enforcement is good for stability. Canadian authorities have argued for years that their willingness to take specific action against risky bank behaviour was a key reason why their institutions survived the 2008 crisis relatively unscathed. In Britain, the Financial Services Authority (FSA) has gone even farther and has shifted over the past couple of years from "light touch" to a far more intrusive approach with an active enforcement arm. The Government is considering even more radical changes as it drafts legislation to break up the FSA and may well give the planned new regulators enhanced powers to ban products and order changes to bank business models when it tables the Bill. The study also found evidence that the average number of supervisors per bank fell, as did the frequency of supervisory visits, in the years leading up to the financial crisis. The drop-off coincided with a sharp increase in risk at some institutions and - as some governments learned - dangerously little preparation for the possibility that volatility could rise.

No cut-backs
Dr Delis believes that history provides a warning: governments seeking to maintain financial stability should not cut back on enforcement during good times, lest they remove a key part of the framework that keeps banks in line. "All in all, efficient audits and enforcement actions seem to work as the best motive for banks to improve their own financial soundness," he said. "It is probably a good thing to sanction banks if you see the risk skyrocketing."

Source: Supervisory Effectiveness and Bank Risk, by Dr Manthos Delis, Senior Lecturer in Banking at Cass; and Panagiotis Staikouras, Assistant Professor of Law in the Department of Banking and Financial Management at the University of Piraeus.

Brooke Masters is the Chief Regulation Correspondent at the Financial Times.