By the turn of the millennium at the latest, the politicians who had lived through the horrors of the Second World War were old enough to retire from the stage. The impact of that paradigm shift can be felt in many places: sabre-rattling is back in vogue. A similar development now seems to be emerging when it comes to safeguarding global financial stability. More than 15 years have passed since regulatory laissez-faire – most pronounced in the United States – nearly brought down the global financial system. 2008 is a long time ago. Many of the players involved have long since moved into retirement. But that cannot be said of the two German supervisors who have caused a stir in recent weeks with strikingly bold reform proposals on the regulation of small banks.

Karlheinz Walch, Director General Banking and Financial Supervision at the Bundesbank, was already dealing with supervisory issues during the global financial crisis. And Nikolas Speer, Chief Executive Director of Banking Supervision at BaFin, experienced the crisis up close in his previous role at Commerzbank, where he was responsible for risk control and group strategy. No one could accuse either of youthful recklessness. And yet, with their discussion papers, they are shaking the foundations of the Basel framework that has been painstakingly built and refined over more than two decades.

From the Bundesbank’s perspective, the proposed relief measures for smaller banks do not actually contradict the Basel requirements. Board member Michael Theurer recently felt compelled to stress that the framework was designed for internationally active banks. Regulators in the United States, however, made a similar case when they exempted regional lenders from the capital and liquidity requirements laid down in the Dodd-Frank Act – a move that came back to haunt them in the spring of 2023. European supervisors have often explained why the US banking turmoil did not spill over into Europe by pointing to stricter adherence to rule-based requirements.

Of course, the proverbial small-town savings bank, the apparent target of the proposed small-bank regime, is not typically a German version of Silicon Valley Bank, which ultimately failed in part because of the mobility of its deposit base. On the other hand, the spectacular troubles that have plagued the cooperative sector for some time show that membership of Germany’s large financial associations is hardly a guarantee of prudent management. What is more, the proposal would by no means only apply to the politically protected savings and cooperative banks, but also to several dozen private-sector institutions in Germany alone – not to mention small lenders elsewhere in the EU, which continue to exist despite more advanced consolidation in many countries.

A small-bank regime that grants national supervisors broad discretionary powers helps justify their existence. But it also opens the door wide to regulatory arbitrage. That is a risk worth weighing up, just as is the fact that institutional protection schemes are a peculiarity of Germany’s financial associations. Policymakers should think carefully about whether to extend the relaxations of the rules to institutions that lack a comparable solidarity system. That debate will take place. As with all European legislative projects, the stakeholders will weigh pros and cons and most likely water down the substance. In that sense, the courage of the two supervisors to rethink bank regulation in terms of outcomes rather than rules is to be welcomed.