Banking sector profitability and lending funds to major segments of the economy are two areas to keep a close eye on as regulators press ahead with reforms, Monetary Authority of Singapore (MAS) managing director Ravi Menon has said.
In a keynote address at a symposium on Asian banking and finance in San Francisco on Monday, he said: "While the effect of regulatory reforms on the broader economy has so far been benign, regulators must continue to pay close attention to the cumulative effects of various reforms and seek to minimise adverse consequences for the real economy."
Even though regulators are not in the business of ensuring profits for banks, said Mr Menon, there is interest there as banks have to be profitable to be strong and to support the real economy.
For instance, he noted retained earnings are one major source of equity, which is in turn the highest quality capital held by banks.
But banks are facing difficulty in "a prolonged period of low growth and low interest rates". Mr Menon said the average return on equity of the 200 largest banks has fallen from 17 per cent pre-crisis - from 2005 to 2007 - to 9 per cent in the period from 2011 to 2013.
"Monetary policy, as it comes up against diminishing returns at the zero lower bound, is also not helping bank profitability. As policy rates are pushed into negative territory in a growing number of countries, the implications for financial stability need to be assessed carefully," he said.
In the current environment where interest rates are low or even negative, banks are likely to engage in market segmentation and charge different rates for different groups of clients, said Mr Menon.
This situation is not ideal as banks become reluctant to impose negative interest rates on retail depositors, and to make up for the interest they have to pay on their deposits with the central bank, they may have to charge their borrowers a higher interest rate, he said.
Mr Menon also explained that poor profitability and low retained earnings will inhibit banks in building up their capital buffers.
"Without sufficient capital buffers, banks may be less willing to lend, which may constrain the availability of financing to the economy."
The global standard-setting Basel Committee has recognised the difficulties and is fine-tuning Basel III capital rules, meant to ensure banks are protected against short-term funding crises.
Some include revising the standardised approaches for credit and operational risk, and implementing the leverage ratio.
Mr Menon also told regulators that a "holistic perspective" is required in the final stage of reforming the rules, and stressed the need for balance. "In trying to get the design right, we must not end up making the overall level of capital requirements too high," he said.
"We have already achieved more or less the right level of capitalisation for the banking industry through the initial set of Basel III reforms after the financial crisis."
He said central banks should not unduly penalise lending to important segments of economies, like trade, and small and medium-sized enterprises, while addressing the limitations in banks' internal models.
With the right balance, regulators will help mould a banking system that is "robust in the face of business cycles and market volatilities, and supports economic growth and creates opportunities for individuals and enterprises".