Post crisis financial environment and regulation: the European banking sector’s metamorphosis?
What has been the impact of the European regulatory framework on the Business Models of banks since the crisis and its consequences on the development of alternative ways to finance the real economy? Regulation post-crisis may be creating incentives for more market-based financial systems—as the protection of depositors led to much stricter rules. Economic theory has compared bank-based vs. market-based systems (see Allen (1993), Allen and Gale (1999), Dow and Gorton (1997).
Regulations on banks have become particularly extensive, especially in Europe
A global response to the subprime crisis—A global agreement, Basel 3, was reached in July 2010 by the G20—around three pillars implemented in Europe (see a Basel 3 for dummies presented by BNP Paribas): (i) a minimum common equity level of 3% of the total amount of exposure; (ii) a minimum common equity level of 7 to 9.5% of the amount of risk-weighted assets (2.5% in Basel 2); (iii) a minimum Liquidity Coverage Ratio (LCR) of the total net liquidity outflows over a 30 days stress test. It will rise annually from 60% in 2015 to 100% in 2019.
Laeven and Ross Levine observe that the governance structure of banks affects how they react to regulations—especially in continental Europe, which is more bank-based and more leveraged (Olszac & al (2014)). The pro-cyclical effect of the one-size-fits-all Basel Regulation is thus a particular concern in the EU (BIS).
And a reinforced European supervisory system—this came in two steps:
The De Larosière Report (October 2008), commissioned by the EC, led to the set up of the European System of Financial Supervision (ESFS): a microprudential pillar with three new regulators (The European Supervisory Authorities and a macroprudential pillar with the European Systemic Risk Board (ESRB).
The Banking Union, initiated to prevent fragmentation of the European financial markets (European Parliament)— built three axes: (i) the Single Supervisory Mechanism (SSM), providing additional supervision; (ii) the Single Resolution Mechanism (SRM), and (iii) the European Deposit Insurance Scheme (EDIS).
Improving the stability of the financial system is a key objective. Goyal et Al (2013, IMF note) pointed out that this single European regulatory framework is likely to remove national distortions and mitigate the risk of concentration that compromises systemic stability, even so banking union without fiscal union is an inherently incomplete and potentially unstable combination according to Nicolas Véron (2015). Furthermore, most banks in the euro area will escape direct supervision by the ECB -especially German, Italian and Austrian banks (Véron, 2014), which could lead to damaging arbitrages (Posen and Véron, 2014).
…Raising questions on the sustainability of banking and on the emergence of a new financial landscape
Chastising the banks: effects and channels.
Leverage measures restrain overall lending capacities (KPMG). The leverage ratio -as a non-risk-weighted measure- particularly affects banks engaged in low margin but high volume lending; and creates an incentive for banks to increase their proportions of risky assets and to reduce their sizes.
The new regulation on risk-weighted assets aiming at building capital buffers could lower capital-allocation efficiency (EBA), encouraging banks to detain a high majority of non-risky assets and thus to raise the level of risk associated with their risky assets to remain profitable. In 2012, the OECD was standing up against this ratio, calling for a restriction of the regulation of Basel 3 on a single leverage ratio based on non-risk-weighted total assets that would help to maximize capital-allocation efficiency (Patrick Slovik, 2012).
The introduction of the Liquidity Coverage Ratio (LCR) penalizes long term investment. This ratio raises the desirability for highly liquid assets to the detriment of other banking assets that are struggling to meet Basel requirements (EBA), possibly contributing to the accumulation of liquidity at the ECB (annual BIS report, 2015).
In practice, banks have recently underperformed in terms of lending to the real economy. Lars Machenil and Walter Rosenhek (2013) assesses that Basel 3 in Europe mechanically narrow the ROE of the 8000 European banks, diminishing their ability to finance the economy. According to the IMF (GFSR last updates), half of the reduction of cross-border lending of the European banks since the pre-crisis period can be attributed to regulatory changes. Such a reduction in cross-border banking flows could have additional reverse effects on the economy (see chap 2).
In the context of the crisis, the regulatory efforts may have amplified the financial cycle (and credit crunch), and the retrenchment of banks from market-making activities (continuing to pose the threat of a reduced global liquidity according to the IMF). Regulation occurred while deleveraging and weak interbank confidence were at play. Increasing risk aversion, liquidity scarcity and greater uncertainty are shaping new banking practices (Forster et al, 2011).
Assessing the impact of regulatory changes is a difficult exercise. Halaj and Kok (ECB, 2014) highlight the scarcity of knowledge concerning how financial networks operate and their sensitivity to regulation. Leaven and al. (2014, IMF) insist on the sensitivity to size. Ignatowski and Korte (2014, ECB) proposes estimates, but limited to resolution regimes.
Toward s a new business model of European banks?
The dramatic shift in cross border lending: towards local and safer operations (GSFR, chapter 2, 2015). A flight to quality and a loss of confidence in the post-crisis environment has been associated with a decline in cross border lending—especially affecting banks in the euro area:
Shrinking direct cross-border lending as a share of total banking assets, mainly due to regulatory reforms according to the IMF.
Steady share of local lending by foreign banks affiliates.
Regionalization of banking networks, with European international banks leaving some market segments -notably Asia.
International non-financial corporate bond issuance has surged. Facing bank credit constraints, large firms have turned to capital markets to secure financing.
According to McCauley, McGuire and Von Peter (2012), such a shift towards more local and likely located operations is more pronounced in some countries like Spain and France. Allen et Al (2011) point out that this might reduce financial risk-sharing and diversification.
The surge of alternatives to finance the economy
The asset management industry: the ‘spare tire’ of finance? Financial regulation measures have been disproportionately affecting banks vs. the shadow-banking sector and market financing (Jon Danielsson, 2015)—resulting in a greater role for the asset management industry as intermediary (Mckinsey, Towerswatson ranking, and attached chart), especially increasing credit intermediation by bond fund (GSFR, chapter 2, 2015). Even if the Asset Management industry remains partly concentrated in the US, Western Europe (especially the UK, France and Germany (EFAMA, 2014)) is driving its growth according to I. Walter.
An opportunity for the EU to promote the Capital Market Union (CMU). European corporations currently mainly rely on bank financing for their external funding. The CMU—an important pillar of the Commission Investment Plan—comes as an alternative of bank funding (a priority in the Conclusions of the European Council), with several goals (Green Paper): (i) lowering barriers for accessing capital markets; (ii) widening the investor base for SMEs; (iii) building sustainable securitization; (iv) boosting long term investment; and (v) developing European private placement markets. The initiative faces the aversion to financial risk in the broader European capital markets and political reluctances to go further in the European integration (Raoul Ruparel, 2015). Building a capital market union could be an effective way to revive cross border lending with a rise of 1.8 trillion Euros in cash and deposits (Valiante, D, 2016). “Divergent accounting enforcement regimes, fragmented market infrastructure, and incompatible frameworks for the taxation of financial investments” are the remaining barriers to overcome, according to Nicolas Veron (Bruegel, 2015).
Market-based or bank based economy? The European conundrum.
A market-based economy seems to provide multiple advantages compared to banks (IMF GFSR 2014), including less exposure to short-term debt, lower solvency risk because of limited leverage (Reuters, 2015), and lower intermediation costs (Les Echos, 2015).
Yet the European asset management industry can a source of risks to financial stability, because of: their (in)ability to take systemic losses in their stride (BoE, 2014), their high concentration (BIS, 2015), their risky positions (e.g., in vulnerable emerging markets (IMF WEO, April 2015)); liquidity risks (IMF).
According to the European Commission economic analysis on building a CMU, “the distinction between bank-based and market-based financial systems seems to be fading while greater emphasis is put on their complementarity”.
Conclusion: Is regulation resulting in a new banking financial landscape?
The European liquidity paradox—while central bankers create abundant liquidity, regulation makes bank lending more difficult (Jacques de Larosière, ESBC, 2013)—possibly drawing economies towards more market-based systems (as reforms of their respective banking systems is overly contentious?).
What should be the next steps? According to the EBA, some lessons need to be drawn from recent efforts: beware of unintended consequences; monitor banks with weak profitability; pay attention to the boom of the asset management industry and to the search for higher yields; do not tighten regulation further during deleveraging. Last of all, some still argue that a “New Glass-Steagall Act" is inevitable if regulators definitely want to bring back banks to their original mandate and limit systemic risks (La Tribune, 2013), akin to the US Volcker rule.
