UK urged to relax Basel rules to curb shadow lending

The UK’s Basel III framework needs to be “rethought” because it is holding banks back and moving lending to the shadow banking sector, a financial regulation expert has warned.

Professor Kern Alexander, chair of International Financial Law and Regulation at the University of Zurich and the director of studies in Law and Finance at Queens’ College Cambridge, told a House of Lords committee that “the regulatory scope needs to be adjusted”.

The Financial Services Regulation Committee is investigating the extent to which the dramatic growth in private market lending since the global financial crisis has been caused by capital and liquidity controls imposed on banks. 

While giving evidence, Alexander said that Basel III has resulted in “lower growth in credit provisions by regulated banks”, meaning firms are turning to under-regulated “shadow banks” for credit.

Non-bank financial institutions have been the source for nearly all of the £400bn increase in UK business borrowing since 2008, while bank lending has remained relatively constant, according to Bank of England data. The non-bank sector now accounts for roughly half of global financial system assets according to global watchdog the Financial Stability Board.

Alexander described banks as “hoarding liquidity on their balance sheets”, meaning small businesses have to turn to non-bank financial institutions for loans.

These NBFIs are “not subject to the same regulatory capital and liquidity requirements” as banks, and therefore have a compliance and cost advantage, he noted.

By contrast, US bank lending has returned to pre-2008 rates of growth, which Alexander attributed to the lighter application of the Basel III rules.

“Most US banks are not covered by Basel III, only the biggest systemic US financial holding companies are,” he said.

The Federal Reserve also reduced Basel capital requirements on US globally systemically important banks last year following extensive lobbying from the banking industry.

In comparison, the Prudential Regulation Authority in the UK has applied the capital requirements of Basel III across the board, Alexander noted.

Further Basel III implementation is facing delays in the EU and the UK due to uncertainties over the US adoption.

The EU has delayed the implementation of the Fundamental Review of the Trading Book until January 2026, despite the ECB warning it would unfairly penalise banks that have already prepared.

These reforms have resulted in NBFIs becoming increasingly important to the UK’s financial system.

Speaking at the same oral evidence session, Oxford university law professor Simon Gleeson and former partner at Clifford Chance, said: “There are a large number of interconnections. Banks lend to non-banks, non-banks lend to banks, and so on and so forth”.

There have been some efforts to increase regulation of NBFIs in the UK, especially following the impact of the LDI crisis. The Bank of England’s Nick Butt outlined how the monetary authority is working to improve NBFI resilience in a speech last year.

According to Gleeson, the biggest danger is risk being passed from voluntary investors to individual bank depositors who are “not aware that they are exposed to that risk”.