- Andrea Enria – Chairperson, European Banking Authority (EBA)
- Per Callesen – Member of the Board of Governors, Danmarks Nationalbank
- Edouard Fernandez-Bollo – Secretary General, Autorité de Contrôle Prudentiel et de Résolution (ACPR)
- Klaas Knot – President, De Nederlandsche Bank
- Arthur J. Murton – Director, Office of Complex Financial Institutions, Federal Deposit Insurance Corporation (FDIC)
- Jose Manuel Campa Fernández – Global Head of Regulatory Affairs, Grupo Santander
- Douglas Flint, – Group Chairman, HSBC Holdings plc
- Richard Holmes – Chief Executive Officer Europe, Standard Chartered Bank
- Urs Rohner – Chairman of the Board of Directors, Credit Suisse Group
The ongoing regulatory overhaul has already made the banking sector significantly more resilient
The combination of stress testing, leverage limits and better risk modelling has improved the line of sight regarding the amount of capital needed
Stress tests accommodate the possible deficiencies that may exist in risk-weighting, because regulators can decide what they should be looking at regarding stress events and then adjust banks' capital positions. There are healthy discussions between banks and regulators concerning the appropriate levels of capital and liquidity required.
The creation of dedicated authorities in many jurisdictions and their constant cooperation represent key improvements in terms of the resolvability
During the crisis, much ring-fencing was encouraged by concerns that a shock would have remained with national supervisors and eventually taxpayers. One lesson learned was that there was a lack of governance regarding resolution. The choices faced by regulators at the time were bailouts or disruption through disorderly resolution, with the resulting consequences in terms of economic and political costs.
In such a context, new resolution authorities have been put in place in many major jurisdictions and started to cooperate together, which represents a transformation of the industry.
However, it is important to ensure a better balance between regulation and resolution
However, the industry in particular considers that there are regulatory challenges from a global perspective for international banks. One issue that stands out in particular is extraterritoriality. Banking structural reform is also a real issue as it traps capital and liquidity, while inhibiting banks from occupying the positions they would like to take up. Consequently, a balance needs to be achieved between regulation and resolution.
The implementation of the new banking regulations is proving to be challenging
Regulatory changes are leading to extraordinary demands in terms of technology and operational resources
The sheer amount of system changes required by the regulation overhaul are leading to extraordinary demands in terms of technology and operational resources. Thus, initiatives that might otherwise be taken, which would be customer-facing, are always at the back of the queue.
It is important that banks should make enough money so they can recapitalise themselves
The stock of capital is one thing that is significantly different between the United States and the rest of the world, especially Asia and Europe. This stock is often considered as the crucial element for protecting the financial system from resolution events, yet it is the flow that is important, i.e. are banks making enough money out of profits to recapitalise themselves and absorb the risk. In this respect, the American banking system is much more profitable than Europe's, so there is much more confidence among investors that the economy can take risks.
However, the industry considers that in Europe, although the system has been made materially safer, people still demand the same high return on equity, because they are expecting the rules to change again. This is due to the fact that the regulators have made perfect regulatory pieces, but no one has tried to find out whether the pieces will actually fit together.
In this context, an (additional) extremely important exercise will be taking place soon in 2016, with the global calibration of post-Basel III reforms, e.g. how asset risks are weighted, and the definition and calibration of TLAC, which would also represent an important change.
Main issues raised by banking regulation
The inconsistency of banking regulation in the EU is having a negative impact on the level playing field and triggering a re-fragmentation of domestic markets
A unified European approach, with the European Banking Union, should be an important step forward to remove any possible criticism of the actual solvency of EU banks. However, the banking sector is of the opinion that one major problem that still exists is the inconsistency between various markets, countries or regions. This is negatively impacting the level playing field and the economy and causing a trend for re-fragmentation into domestic markets. This is having a negative impact on the ultimate goal, which is to have a stable system and to ensure that enough credit can be provided for the economy in general.
The regulations are also too complex and insufficient time has been spent on their direct impact on the stability of the financial system
The regulatory reform represents thousands of pages of new rules, which are not always consistent, and insufficient time has been spent on the aggregate economic impact of these regulations. The EU review of the possible cumulative impacts of the financial regulations, considered in terms of jobs and growth and not just safety and soundness, illustrates the fact that having more liquid and better-capitalised banks comes at a cost to the real economy.
International banking regulations are unable to address the specific features of the various banking sectors and economies around the world
A speaker from the industry stressed the regulatory community's obsession with consistency across the North American, European and Asian economies, although they are starting off with differently shaped financial systems at different stages of evolution.
A further change in banking regulations is already on the agenda
Further consistency regarding risk-weighting is necessary, whereas risk sensitivity and counter-cyclicality are essential
A public policymaker stressed that analysts and market participants perceive that although the banks have similar portfolios, they also have completely different risk weighted assets. A level playing field also means equal treatment exclusively for equal cases. Yet in the EU, retail markets in particular are still fragmented along national lines, because national legislation, non-banking regulation, tax legislation and national guarantee systems play an important role in the risk profiles of individual loans.
One way to improve this is more transparency and more sharing of information across the industry, regarding loss experience as well as RWA formulas. Benchmarks could be established to measure deviations.
One concern is that possible risk-weight floors may focus bank management efforts on reducing the risk weights related to higher risks. This will not enhance either the transparency or the health of the system. A balance should be struck between adjusting capital positions to the right level and having regulations actually micromanaging the banks.
Many agreed on the fact that reinforcing the role of supervision should improve comparability, particularly since the regulators have much to do with the inconsistency since they have different approaches for implementing risk models which depend on the parameters that they define. Supervision should however be able to adapt requirements to the different phases in the cycle. Nevertheless, this is challenging since it requires more confidence in supervisory judgement in Europe. Lastly, making risk weightings uniform is expected to destroy risk sensitivity and counter-cyclicality.
Despite the significant progress made, the actual resolution of a cross-border bank is still a complex and fragile process
The participants agreed that the FSB has done a great deal of work regarding bank resolution. For individual institutions, defining recovery and resolution plans enables them to better understand their own institutions in the event of a crisis. The process in place, by which every G-SIFI (Global Systemically Important Financial Institution) works with regulators on an ongoing basis and reviews these plans, increases the likelihood of the resolution plan working.
Conversely, any ring-fencing of a domestic operation would make resolution more difficult. These problems are notably due to differences in national legislation. The real issue that still needs to be addressed is how to construct a resolution system that extends across borders. It will only work if national institutions remain disciplined. Very diligent work among the various jurisdictions is being done to overcome some of these cross-border issues.
However, a bank underlined that the outcome is extremely complex since a resolution and recovery plan for a global institution is normally 20,000 pages long. Consequently, one feature should be common principles shared by all the relevant jurisdictions, regarding the structural changes required by resolution and recovery plans, and the interplay of home and host regulators.
TLAC will improve market discipline, but they should further factor in the adaptations made by banks to become more resolvable
An effective resolution regime means that the consequences of private sector decisions stay within the private sector, as opposed to being imposed on the public sector. This is what TLAC is all about. Their subordination is a key element in order to ensure legal certainty that the bail-in can be applied. The challenge is to minimise the concerns among more senior creditors that they might be bailed-in, by clarifying up front who will be affected by a bail-in.
A banking industry representative stressed that the efforts to adapt the business models and the daily constraints imposed on ongoing operations, so that banks are easier to resolve, should be reflected in lower regulatory burdens, notably those related to TLAC, which are turning out to be higher and higher.
The regulations may need to be adjusted to improve the capability of banks to finance the economy
The pace of bank recapitalisation and the credit cycle strongly influence the capability of the banking system to finance the economy
Each new regulatory initiative has been accompanied by a quantitative impact study on which the pace of the implementation has been calibrated. The problem is that the market then runs ahead of the transition period.
The most stable lending to the real economy is provided by the better-capitalised banks. In this respect, Europe waited too long to recapitalise the banks. Furthermore, the Basel Committee views the European Union as somewhat laxer than the United States, where lending has recovered faster. However, whereas 2012/2013 were years when deleveraging took place in the EU, the credit cycle has started to turn and the economy is now in much better shape.
An executive from the banking sector explained that there is no evidence that supply of credit to the real economy has been materially constrained, but he stressed that in a world of Quantitative Easing (QE), hindsight is likely to show that it was very difficult to detect negative trends. Lastly, the broader picture is a policy mix, where there is a clear tightening of regulatory requirements, but also a relatively easy monetary policy, which has allowed the banks to move to a new equilibrium with respect to regulatory requirements.
The private sector fears that the combined impacts of the whole regulations, including level 3 measures, may eventually impair the economy's recovery
An industry representative was of the view that the industry is much better off than prior to the crisis, but there is fatigue. However, there is still a lot to come: looking beyond TLAC and MREL and redefining the leverage ratio, on a more technical level, there is a lot of work to be done for recalibrating both Basel III internal and standard models. For industry analysts, the outcome is very worrying; it represents between 150 and 220 basis points of additional capital.
Although the impact of calibration on the real economy is very difficult to assess, the main unintended consequence of this whole reform would be that it has not been able to accompany the real economy's recovery. Today, the dependency on unorthodox monetary policies is still incredibly high, with very limited possibilities of being able to leave them.
EU regulators agreed with the need to have a greater ability to move the regulatory tools across the cycle. These can work well when there is a need to tighten them, but they may not work as well in recessionary conditions, although alleviating regulatory requirements might have relevant effects, because this is a time when commercial and market pressures lead banks to be restrictive. Such a situation is also putting huge pressure on the profitability of banks and eventually capital flows and the related effect on bank business models.
A vision needs to be worked out in order to shape the regulations appropriately
Since the aggregate impact of many very well targeted individual initiatives might not produce the intended general result, a common vision should be defined concerning what the financial system should do and then regulation should be shaped to deliver that. The industry is infinitely adaptable. It can adapt to the capital regime, once it knows what is expected.
In this respect, financial stability is about a sustainable supply of finance to the economy, adequately capitalised and properly remunerated. One should also consider the big difference between the United States and Europe, which is that the United States does not finance mortgages on banks' balance sheets, and they concentrate bank capacity on things that only banks can do, i.e. SME financing.
This is a major public policy decision and it should be made consciously rather than drifting into it by accident through regulation, because of the regulatory base levels of RWAs (Risk Weighted Assets) or leverage ratios.
Further focus on SME equity positions should help growth to resume
Many speakers agreed on the fact that the SME sector is extremely fragile in the EU, especially in some countries, attention should also be directed to other measures to restructure and ensure that there is more equity in SMEs, since the last thing that many SMEs need is more leverage. However, since many of these small companies are family-owned, it is not easy for them to find equity, or to accept that finding equity means they have to share ownership with external equity holders.
Although all the speakers acknowledged that the most appropriate channel to provide financing for SMEs is the banking sector, there is a challenge since banks are probably not the best channels to provide equity-type finance for SMEs.
1. The inconsistency of banking regulation in various markets and countries has a negative impact on the level playing field, triggers a re-fragmentation of domestic markets and fails to fully achieve a stable system
An industry representative opened the discussion with the suggestion that it was necessary to distinguish between the intended consequences and the unintended consequences of any regulation. From the perspective of a globally active bank, it was clear after the crisis that the deficiencies of the system as a whole had to be rectified, and new capital requirements were basically welcomed by the industry. Provided that ultimately, the question is absolute calibration, he expressed the opinion that one of the two major problems that still exist today is the inconsistency that still exists between various markets and countries or regions, and which has a negative impact on the level playing field. That has significant economic consequences. The second issue is an increasingly apparent trend towards re-fragmentation into domestic markets. At all levels, ring fencing in certain jurisdictions is having a negative impact on the ultimate goal, which is on the one hand to have a stable system and on the other hand to make sure that there exists the ability to provide enough credit for the economy at large, and in particular SME companies.
He also said that it is doubtful whether the end goal has been fully accomplished because the complexity factor that came into the system as a result of this regulation should not be underestimated. Indeed, he said, while so much of time has been spent on regulatory reform and new rules have been devised - thousands of pages of new rules that are sometimes not always consistent - insufficient time has been spent on the direct, economic impact of the aggregate of this regulation, and on the intended goal, namely to create a stable system.
He stressed that this raises the question therefore of whether there is now a more stable system or not, the answer to which can be found by considering the direct impact, he said. One thing was clear in his opinion: market liquidity in certain areas has been reduced. This is clearly not desired, particularly in the Eurozone; SME lending has recovered significantly given that for the time being there is a system where 70% of lending actually comes out of banks, not the capital markets, and this will remain the case for quite some time. This is something, which should cause concern. Volatility in the markets will increase, in particular if there are more difficult situations. The fact that market makers have actually had to reduce their balance sheets will have a negative impact on volatilities in distressed times and there will be much bigger spikes. There is also abundant evidence for that.
This raises the question therefore of whether there is now a more stable system or not
In many other areas, much progress has been made within resolution. TLAC (Total Loss Absorbency Capacity) calibration is probably the most important issue still to finalise. Again, if different treatments in different countries are allowed the intended policy goal may not be achieved.
2. The swiftness of bank recapitalisation and of the credit cycle strongly influence the capability of the banking system to finance the economy
A representative of the public sector from a Member State also focused first on the overall impact and the calibration. He said that it was not yet clear whether the calibration is right or not and that this will only be known after having lived it for a certain period. However he stressed that before the crisis, everyone got calibration terribly wrong: the illusion that an internationally-active bank can be run on essentially 2% core equity of risk-rated assets has been shown to be a very costly illusion.
He reminded the audience that however, the regulatory community, be it Basel or the institutions in Europe, has been very cautious in accompanying every new regulatory initiative with a quantitative impact study and subsequently trying to calibrate the pace according to what is achievable without having an overly detrimental effect on the banks being able to carry out their function.
When considering the question of what is feasible and what the effects are in terms of deleveraging, a distinction should be made between what is actually the steady state and what is the transformation needed to attain this steady state. In the steady state, there is no debate that the most stable lending to the real economy is provided by the better-capitalised banks. So the better capitalised the banking system is, the more stable credit provision for the real economy can be. There is also a hint now, if one considers the swiftness with which some jurisdictions recapitalised their banks and also the swiftness with which the credit cycle turned in various countries that Europe has not been on the right side of this equation.
He stressed that Europe waited too long to recapitalise the banks. The credit cycle in Europe shows that 2012/2013 were years in which deleveraging took place, but as soon as the comprehensive assessment was completed, the credit cycle also started to turn and the economy is now in a much better shape than for a very long time, if the more recent credit numbers are considered.
Regarding the impact of the financial regulations on the economy he also highlighted the fact that since the crisis the broader picture is a policy mix, where on the one hand there is a clear tightening of regulatory requirements, but on the other hand, a fairly easy monetary policy. That element should not be forgotten, he said, because part of the monetary easing that has been conducted by the Central Bank has also allowed the banks to move to a new equilibrium with respect to the regulatory requirements.
the monetary easing has also allowed the banks to move to a new equilibrium
Obviously, it has taken a long transition period to get from one steady state to another. With Basel III, that has been compounded by the problem that a transition period can be fixed, but nonetheless the market then runs ahead of the transition period and much of the recapitalisation needed then gets moved forward in time. That clearly played a role in the years 2011/12/13. This is now past.
The main outstanding issue now is actually MREL (Minimum Requirement for own-funds and Eligible Liabilities) and TLAC. Front running is unlikely to be a problem, because a bank and its financiers would be foolish to actually front run the moment at which they would qualify themselves for being bailed-in.
Even if there is agreement on what the standard for TLAC should be, and if a time-scale until 2020/2021 is allowed, there will be little probability that the requirements will be moved forward in time, because there are really no incentives to do so. That is an important distinction to keep in mind between the TLAC/MREL on the one hand, and the Basel III going concern capital requirements on the other hand, he said. The TLAC proposals that are currently on the table were accompanied by a quantitative impact study. The range that has been presented is a feasible one. It means that a great deal of senior debt that is currently outstanding in the coming years will have to be gradually replaced by certificates that are subordinated.
He insisted on the fact that subordination is indeed going to be a key element in the TLAC-MREL discussion because without subordination, there will not be the legal certainty that the bail-in can be applied as was intended by the BRRD (Bank Recovery and Resolution Directive). There is a German proposal on statutory subordination, which is a right step in the right direction. In this respect the speaker’s preference would actually be to combine that structural subordination with a contractual one. He explained that minimising the contagion of fear among more senior creditors by clarifying up front who will be affected by a bail-in seems positive, whereas a statutory requirement will still imply that individuals might be bailed-in, who are not anticipating or prepared for it.
A speaker from the public sector noted that in Europe there is concern that the weight of the re-regulation and what is still in the pipeline is really having an adverse effect on recovery and especially on SME lending. He wondered what the difference is between Europe and other jurisdictions since in a sense, he said, the United-States have the same type of requirements. He stressed in this respect that the Basel Committee has reviewed and the European Union has come out as materially non-compliant with the Basel standards, so it seems somewhat laxer than the United States. Yet, lending in the US has recovered faster. One explanation is in his opinion that they frontloaded the adjustment of banks to the regulation earlier.
the economy is awash with liquidity and investors are looking for yield
An executive of the banking sector explained that there is no evidence that supply of credit to the real economy has been materially constrained, but he was of the opinion that there should not be complacency because this is a world of Quantitative Easing (QE). The risk-free rate has been taken down to a level that many would think is unrealistic, and the economy is awash with liquidity and investors are looking for yield. Consequently he said that this is a world where it is likely that hindsight will show that it was very difficult to detect negative trends.
3. Banks making enough money that they can recapitalise themselves is one important aspect
He added that one of the things that are significantly different between the United States and the rest of the world, especially Asia and Europe, is the difference between stock and flow. The stock of capital is often considered as what is important to protect the financial system from resolution events, and yet it is the flow that is important i.e. are banks making enough money for them to recapitalise themselves out of profits and absorb the risk? There he stressed that the American banking system is much more profitable than Europe’s. Net interest margins are much wider than in Europe and, therefore, there is much more confidence among investors that the economy can take risks, because the generation of capital within the system organically is significantly higher than what is accepted as profitability in Europe.
4. The level of Return on Capital demanded from banks suggests that investors expect further evolution of bank regulation
In such a context he underlined that one of the extraordinary things is that the system has been made materially safer, even though the requirement for return on equity of investors in European banks has not moved. The system is safer, but people still demand the same (high) return on equity. That is either illogical or it is because people do not think that the agenda is finished and they are holding capital back because they are expecting the rules to change again. In terms of the regulations, the speaker made an analogy with asking jigsaw makers to make perfect jigsaw pieces even when no-one has produced the lid to show what is being made and to find out whether the pieces will actually fit together.
5. The required consistency of banking regulations will be unable to address the inconsistencies of the various banking sectors and economies across the world
The speaker added that there is an obsession within the regulatory community with consistency which is not matched however in the real economy or by the industry. The North American economy, the European and the Asian ones, start off with differently shaped financial systems at different stages of evolution. It would be extraordinary if one size could fit all and if there is an attempt to achieve this it may end up damaging those parts of all the economies that do not quite fit with the required type of micromanagement imposed on individual risk weights.
6. The combination of stress testing, leverage limits and risk modelling, has improved both regulators and institutions’ line of sight over the amount of capital needed
Two of the other things that have been achieved, which are really important, are the leverage ratio and stress tests. Stress tests in many ways accommodate the deficiencies that may exist in risk-weighted asset measurement because regulators can decide what they want to do in terms of looking at stress events and can then guide banks toward the capital position that those stress events would require. So the combination of stress testing, leverage issues and a risk-weighted asset, risk-based modelling, has actually massively improved both regulators and institutions’ line of sight over the amount of capital needed.
7. Regulatory changes are extraordinarily demanding of technology and operational resources
The sheer amount of system changes required for what seemed quite simple regulatory changes concerning risk-weighted assets are extraordinarily demanding of technology and operational resources. Initiatives that might otherwise be taken, which would be customer-facing, are always at the back of the queue, because the regulatory imperatives take precedence since they are mandated. So, hopefully the point will soon be reached where there is a pause and no further regulation is added. There should be an assessment of what has been done in Europe, at least on the aggregate impact, to see whether it is good enough, rather than perfect, because perfection will never be achieved.
8. A regulatory pause is coming and the Commission will check the effects of what has been achieved
There is fatigue both on the side of the banking industry and on that of the regulatory community in terms of production. A pause is, indeed, coming at the end of this cycle and the Commission has already announced there will be an opportunity to look back and check what the effects are of what has been done to date.
9. The creation of dedicated authorities in many jurisdictions and their constant cooperation represent a key progress in terms of the resolution and resolvability of financial institutions
A representative of the public sector also alluded to the fact that during the crisis, much ring fencing was encouraged to a large extent by the concern that in the event of a shock, the problem would have remained with the supervisors and regulators and eventually taxpayers in the initial jurisdiction. He questioned consequently the progress made, in terms of dealing with the issues of resolution and resolvability, and how far this would allow the ring fencing that was put in place during the crisis to be undone, re-establishing the right framework for cross-border banking globally.
An international representative of the public sector explained that with respect to resolution, the FDIC (Federal Deposit Insurance Corporation) has been focused on implementing the new authorities that were created after the crisis. A lesson learned from the crisis was that there was a lack of governance with respect to resolution that made it necessary to provide policymakers with better choices. The choices that they faced at that time were bail-outs or disorderly bankruptcy. In the U.S., a newly expanded resolution regime was adopted that extends the regulators' ability to resolve firms beyond just insured deposit-taking banks to certain other systemically important financial firms, and the FDIC has been working diligently to implement that framework. The consequences of not having such an expanded resolution regime in place became apparent from the crisis, in particular in terms of the economic costs of the great recession.
In terms of international engagement, he explained that other major jurisdictions also have adopted new or expanded resolution regimes and that those jurisdictions have been working very closely together regarding implementation. For example, there has been on-going bilateral and multilateral dialogue among U.S., U.K., Swiss, and Japanese authorities, and with the new European Single Resolution Board (SRB). Many of these authorities engaged in a collaborative manner with ISDA (International Swaps and Derivatives Association) to address concerns about the disruption in resolution caused by the early termination of financial contracts. Working with industry, progress has been made in that regard. Similarly, he noted TLAC as another example of what these (and other) jurisdictions have negotiated under the auspices of the FSB (Financial Stability Board).
An industry representative concluded that clearly there are regulatory challenges from a global perspective. He agreed on the fact that indeed the various economies are at different stages of development, so a 'one size fits all' approach becomes a real challenge. He added that than other aspect of the international impact of these things is where extra territoriality becomes an issue. Developments like EMIR Article 25 and equivalence regimes, he said, have caused some challenges for international banks operating in other markets. It is necessary to be pretty sensitive about the international impact of whatever is planned in Europe.
He also agreed on the fact that achieving a balance between regulation and resolution is important. The two could be thought of as doctor and undertaker, he said. Then he stressed that bank structural reforms are a real problem because they have an impact on banks’ survival. He insisted that such a reform traps capital, traps liquidity, and inhibits a bank’s ability to occupy positions that it would naturally offset, and that constitutes a real cost and a danger.
However he remarked, on the other hand, it is healthy for there to be a discussion with regulators on what an appropriate level of capital and an appropriate level of liquidity are, and everyone from both industry and regulators agrees that they got this horribly wrong before the crisis.
Finally he said that whilst it is hoped that it is more or less right now, the reality is that this is not yet known and that is in itself a little frightening. He alluded in this respect to the fact that Commissioner Hill is reviewing the cumulative impact and is looking through a lens of jobs and growth, not just safety and soundness, and was of the opinion that this is one of the other balances in the equation and stressed that whilst it is fine to aim for banks to be better capitalised and have more liquidity, this comes at a cost, and it is not yet known whether the correct calibration has been achieved.
He expressed in addition the need to ascertain what the impact of banks holding this extra capital and liquidity would be on the real economy in a normal-looking economy provided that at present, the world is awash with money and it is not a normal environment.
He ended by highlighting the challenges related to the calibration of the banking regulation, which must in his view be kept in mind and the cumulative impact better understood. In this respect he quoted the UK, which has already had structural reforms and would not want to re-open this issue due to the structural reforms being proposed or discussed in Europe. He also quoted a discussion about the de minima rules accepted by the Council that are now being questioned. And he warned that there must now be an end to that debate.
what the impact of banks holding this extra capital and liquidity would be on the real economy
10. The calibration of bank regulations at the international level is quite a challenging objective for Europeans, and one, which requires constructive participation from the industry
In such a context a European regulator insisted that an extremely important exercise will soon take place, which is the global calibration of post Basel III reforms. He explained that if there is a great change in how asset risks are weighted, the definition and calibration of TLAC, which has to be done starting next year at the international level, would also represent an important change. In addition, a European unified approach, with the European Banking Union, should be an important step forward as setting banking standards will remove any possible criticism of the actual solvency of EU banks. He acknowledged however that such a calibration of bank regulations at the international level is quite a challenging objective for Europeans. He stressed in this respect that rather than the usual industry’s first reaction, which may just be that calibration is excessive, there must be constructive participation from the industry as these are complex topics. The industry must be more precise to ensure that everyone gets it right.
11. The banks expect that the combination of the effects of the whole regulation for banks, specially level 3 measures may eventually impair the recovery of the economy
An industry representative was of the view that the industry is much better off than prior to the crisis, but there is fatigue. It is necessary to be careful, because there is much still coming and this does lead to a paradox right now. On the one hand the perception in the supervisory authorities is that beyond TLAC and MREL and redefining the leverage ratio, the objectives have more or less been achieved and the framework is already set in place. However, on the other hand at a more technical level, there is still the view that there is much work to be done for recalibrating both Basel III internal and standard models, which may be set too high. In addition, when the analysts within the industry are assessing how this is examined, the outcome is very worrying. Basically over the last three or four weeks a number of analysts have come forward to say that all these things that are coming to the fore are all but trivial. Eventually the impact is in the range of between 150/220 basis points of additional capital for banks, which is a level unexpected by the supervisory authorities resulting from the many technicalities, which in addition are very costly to implement. That is why clarity and predictability are very important aspects as we move forward.
A second area of unintended consequences is the impact of calibration on the real economy. This is very difficult to assess. He explained that six to eight years after the crisis, unintended and maybe even intended consequences are happening. First, he said that in many poorer countries, particularly in Europe, wages and growth and the economy are not picking up. Even in the United States wages are not increasing, although the economy is recovering, and unemployment is increasing. Finally he stressed that there is still an incredible dependency on unorthodox monetary policies with very narrow possibilities of being able to leave them and get back to a normal scenario. Such a combination is putting huge pressure on the profitability of banks and on business models.
He concluded by emphasising that while initially, the concern was about the stocks of capital, during the next ten years concern will concentrate on the flows of capital and the related effect on bank business models. He explained that indeed investors are asked to put money into banks that have a regulatory framework upon which they will be unable to provide an appropriate return on capital, and that will not result in big products in the future. However the main unintended consequence of this whole reform would be that it has not been able to solve the real underlying problem, which is the recovery of the real economy.
A banker on this topic considered that sometimes it is necessary to take stock and have agreement as to the overall aim and objectives, because there is concern that the aggregate impact of many very well targeted individual initiatives will not produce the intended result. Banks are in a privileged position in an oligopolistic marketplace; they have the privilege of being able to take deposits and play an essential role in the transmission mechanism between public policy and economics and getting money to the economy.
There should be a vision as to what the financial system should do and then regulation should be shaped to deliver that. Financial stability is about a sustainable supply of finance to the economy, adequately capitalised and properly remunerated. The industry is infinitely adaptable. It has come through extraordinary economic and technological progress. It can adapt to the capital regime, once it knows what is expected. If the capital requirements are too high, then activity will flow to another sector. That is fine, as long as that is what public policy desires. Once a capital framework is established the industry will work with the official community to create a system, with its own efficiency and some support, as in any regulated industry that has a capital position imposed on it, to make sure that the remuneration of that capital is sustainable. At the moment there is no public policy agreement as to what the financial system should look like, particularly in Europe.
Financial stability is about a sustainable supply of finance to the economy
Discussing SMEs is currently seen as politically correct, however the big difference between the United States and Europe is that the United States does not finance mortgages on the balance sheet of banks, because they are non-productive assets. They concentrate bank capacity on things that only banks can do. In Europe, the vast majority of mortgages are on bank balance sheets. They obviously create wealth, but they do not create economic activity. That is a big public policy decision and it should be made consciously rather than drifting into it by accident through regulation, because of the regulatory base levels of RWAs (Risk Weighted Assets) or leverage ratios. There should be a joint agreement as to the aims to be worked towards.
Finally an EU regulator agreed with the need to have a greater ability to move the regulatory tools across the cycle. It was apparent throughout the crisis that these can work well when there is a need to tightening them, but may not work as well in recessionary conditions. Alleviating regulatory requirements during a downturn is going to have a relevant effect, because that is the moment at which it is more the commercial and market pressures that are leading banks to be restrictive.
need to have a greater ability to move the regulatory tools across the cycle
There is a strong intention for the Commission to have a serious overall assessment of the system that has been put in place and the way in which the Commissioner starts is by gathering consultation information from all stakeholders. The question is how to shape this review in an effective way, how to address the overall impact.
12. Further improvements of bank regulations might end by making them too complex and less risk sensitive
Responding to the Chair’s question of how the complexity in the regulatory system could be addressed to give certainty to the industry, an EU public sector representative considered that there were three issues. The first, resolvability, is extremely important, he said. This is not just about calibrating the TLAC and the MREL, it is about getting resolution and recovery planning right.
Second, with regard to risk weighting there is a need to preserve the risk sensitivity of the system. In this area the speaker was very sceptical that the system could be simplified and made more comparable if the risk sensitivity of the system were reduced. It is already quite complex. Indeed he said that there are internal risk models, a standardised approach, a leverage ratio, and stress testing. If many risk weight floors were added, possibly also reducing risk sensitivity, the system would not only be over-determined but also much more complex. Specifically, there might be a labelling problem. For example, a mortgage is a mortgage, whatever market it comes from. Though national economies differ there are very good reasons, which explain why mortgages and related risks are different. Indeed, one can observe different LTV (Loan To Value) ratios and standards in national markets, and different foreclosure procedures and different rules on personal liability. If these differences are not accounted for, the regulatory system featuring higher risk weights than warranted, may drive mortgage-lending standards down to a lower level.
The third issue is to get the right balance between stability and growth. For example, reducing banks' capital is likely to prevent lending rather than stimulate it. Every time that markets and regulators get the sense that banks are still striving for a very weak capital position, they are incentivised to push back with more and more complex detailed regulation. This could be improved by having larger buffers and larger capital positions and then looking at how to address the details. He concluded by alluding to another balance, which has to be considered. It is, he said, the balance between adjusting capital positions to the right level and having the regulation actually micromanaging the banks.
13. Investors and analysts need further consistency regarding risk-weighted assets
Another public decision maker was of the opinion on risk-weighted assets, that this is not moving in the direction of heavier re-regulation that defines from the supervisor side where the risk weighted assets are. Rather, he stressed that an issue is being addressed, which has also been raised by analysts and market participants, who perceive that though the banks have similar portfolios they also have completely different risk weighted assets. He also said that the regulatory community has much to do with that, because the different ways in which models have been implemented and approved rely on parameters defined by supervisors. This is more of an effort of consistency than a tightening of rules that, in any case, needs to be done in order to move forward. Given the time being invested on this, the speaker wondered how useful this work on consistency is supposed to be and where the industry would like to see it move.
A national public sector representative said that finally, with regard to comparability, a level playing field means equal treatment for equal cases, but it does not mean forcing equal treatment on unequal cases. Some markets, particularly the retail markets in Europe, are still very much fragmented along national lines, because it is national legislation, non-banking regulation, tax legislation, and national guarantee systems that play an important role in the risk profile of the individual loans. High loan to value ratios are very risky, so the treatment of any good risk weighted assets should include the feature that the risk weight should go up very aggressively with the loan to value ratio and that is invariably true in all jurisdictions.
A banker agreed that the goal really is that equivalent risks in different institutions get equivalent treatment. That is really what the industry wants to strive for. It is not necessarily about simplicity, because this is a complex area, but the aim is equivalent risks treated the same way. One way to get to that is more transparency and more sharing of information across the industry, across banks, in loss experience as well as RWA formulas. Much can be done as an industry in this regard to encourage more consistency so that there is equivalent treatment for equivalent risk.
A public sector decision maker expressed the view that there is probably much to be done in terms of transparency and there are very good reasons for checking the consistency of risk weights across banks and across countries. Benchmarks could be established against which the risk weight could be measured and a deviation from such a benchmark would need to be explained. That makes good sense. However, one fear is that if risk weight floors are imposed, but the overall capital position is not tightened, almost by definition the risk weight will increase where the risk is very low and on the other hand, the risk weight will have to be reduced where the risks really exist there and that will not enhance either the transparency or the health of the system. This must be avoided, but more can be done in terms of transparency.
With regard to the question of risk-weighted assets, a supervisor said that there are ways to ensure comparability. The worst way will be uniform risk weight. That will remove any risk sensitivity and this is precisely what is not needed. The real challenge is how to balance regulation in a context where monetary policy will not be indefinitely easing; there must be a way out of this, rather than postponing it indefinitely because there are market problems or similar things. It is very important that regulation and monetary policy should work well in circumstances other than those today, and for this, the key is risk sensitivity and, because there is a balance, counter-cyclicality. It is necessary to be able to adapt the requirements placed on the financing sector to the cycle. These are two things that should be preserved and making risk weightings uniform will destroy this, because they cannot move in either way.
The worst way will be uniform risk weight. That will remove any risk sensitivity
Another way to try to find risk comparability, the supervisor said, is reinforcing the role of supervision. This is exactly the aim in Europe. There will be a common methodology to validate models and risk weights. It is hoped that this will create more consistency and comparability than removing risk sensitivity, and will prove by working that supervision can adapt requirements to the different phases of the cycle. Both macro-prudential and micro-prudential regulations are needed, but this is a challenge and the way to do it is certainly to have more confidence in supervisory judgement in Europe.
14. Further focus on SME equity positions should help to resume growth
SME lending is always a hot topic in Europe. In this topic, the public sector speaker wondered whether there might be sometimes an excessive emphasis on the role of bank capital requirements and on SME lending. Actually he stressed that the SME sector is extremely fragile in the EU, especially in some countries, so perhaps rather than simply debating on bank capital requirements that may favour resuming growth, attention should be directed to other measures such as how to restructure and make sure that there is more equity in SMEs.
In this area a representative of the private sector acknowledged that SMEs are very important for Europe. There is a very good case to be made that probably the most appropriate channel to provide financing for SMEs is the banking sector. It is difficult to provide appropriate earnings if they are financed through other systems. This debate sometimes gets mixed up with the appropriate balance sheet that SMEs should hold. There is also a very good case to be made that probably banks are not the best channels to provide equity-type finance for SMEs. There is a challenge that, as a result of the crisis, and also for new ventures, the real demands for these firms are probably more on the equity side, than on the debt side. The public debate is usually just about SME financing through banks, but there is clear complementarity of both sources of financing. Political leaders just do not make this distinction.
A public decision maker agreed that there is too much emphasis on bank loans to SMEs. He stressed that if the balance sheet of many SMEs is examined, the last thing they need is more leverage or more loans. These problems are inherent to the SME sector. Obviously, many of these small companies are family-owned, so it is not so easy for them to find equity, but some of them also do not want to accept that finding equity means they have to share ownership with external equity holders. These problems are much more fundamental for the SME sector than the lack of bank loans.
15. Despite important progress being made bank cross border resolution is still a complex issue to be addressed
An industry representative said, with regard to resolvability, that general conclusions could be drawn. First, he was of the opinion that it is vitally important for the system that there should be a resolution mechanism in place that actually works. He pointed to the fact that the US system is very good for the internal US market, or domestic banks; however in his view the real problem after the crisis is how to construct a resolution system that actually extends across boundaries. For example, even with all the powers in the US, he said that a UK judge could block the UK subsidiary of Lehman Brothers. This is the basic starting point for discussing resolution mechanisms and is an area where the industry and regulators have worked together very well. Many things that are now almost common features were jointly developed, up to bail-in and TLAC. However he underlined that this is all extremely complex as, for example, a resolution and recovery plan for a global institution normally extends to 20,000 pages, and there might be required similar ones from the different jurisdictions where the institution is present. Consequently he suggested one feature should be common principles. He acknowledged however that the FSB has done a great deal of work on this aspect and there is consensus that it will work, even if the implementation is still to be carried out and actual cases are to be tested.
Furthermore, he reminded the audience that the combination of the capital and the structural changes required, coupled with the common understanding as to how the interplay would work with between home and host regulators in the event of a real crisis, is the determining factor. He said that in the whole process of getting to recovery and resolution plans for individual institutions, it was more important for those institutions to undergo the exercise in order to understand much better what their own institutions actually look like and where the issues lie in the event of a crisis, than having a plan somewhere in a drawer to be pulled out in an actual crisis. Consequently he said that if there is an ongoing process in place where every G-SIFI (Global Systemically Important Financial Institution) works with regulators on an ongoing basis and reviews those plans, there is a very good chance that in the case of an actual crisis the resolution plan would work. However, he said, it will only work in such an event, if discipline remains among regulators or national institutions. Indeed he stressed that conversely if suddenly, in such a situation, the rules were to change and people were to say that it is necessary to ring fence a domestic operation, then it would become more difficult.
Yet he was of the opinion that generally, the resolvability topic demonstrates that industry and regulators can work together and actually achieve a stated policy. He concluded by saying that though TLAC is probably the last piece of the puzzle that has to be resolved, there is a system in place now that is designed in such a way that there is a very high probability that it will work, even in a very severe shock.
Another representative of the private sector said that, on the TLAC proposal, there is not that much reason so far for markets to force banks to anticipate them. Yet he reminded the audience that the way it has worked in the past is that analysts and investors thought that the supervisory authorities could impose restrictions on banks, unless early on a clear path exists making sure that all the requirements are fulfilled. Indeed, the bank is in a situation by which it will be driven to formulate specific demands, such as extreme limitations from the supervisor on the ability to distribute dividends and the need to accumulate equity-type instruments early on. Regarding the definition of TLAC, the authorities should rapidly clarify these types of possible demands because of the markets and also because the banks are working with new authorities in many places. In Europe, there is a new SSM and new resolution authorities, and there is a new authority in the US.
Regarding this aspect an EU public decision maker explained that the risk is not that the markets force the institutions, but that the supervisors will actually be the ones who will invite banks to implement the TLAC prematurely. However, it would be odd for a supervisor to calibrate a standard and then make contradictory demands once it is implemented. It is not the intention of the supervisory authorities for the regulation to work this way, so this is not a high risk and the industry should not be too concerned about it.
A decision maker from the public sector noted that there has been very diligent work among the various jurisdictions to address, through pre-planning, certain of the cross-border obstacles to resolution. Benefits of this resolution planning include enforcing market discipline and requiring firms to internalize negative externalities.
A representative from the industry acknowledged that there is no question that the resolution issue has been a major improvement, relative to the past, in terms of making sure institutions can unwind in the event of a crisis situation. He stressed however in this respect that some of the problems that have been experienced during the financial crisis are due to differences in legislation and in national orientations. Banks have adapted accordingly their business models and followed strategies to address the daily constraints on their ongoing operations, so that they are easier to resolve. He was however of the opinion that such efforts should be reflected in a lower regulatory burden. Yet, he stressed that the demands ex ante for resolution in terms of TLAC are turning out to be higher and higher.
Banks have adapted ... their business models and followed strategies to address the daily constraints on their ongoing operations ... such efforts should be reflected in a lower regulatory burden
A further point, an EU decision maker said, is how to avoid the resolution planning work is segmenting the markets, by crystallising a segmentation of the banking market that has just been inherited from the crisis. In Europe, there are joint decision processes, so if there is an agreement between national authorities on how to deal with the bank in a crisis, this should help in good times to let capital and liquidity flow more freely cross-borders.
By Arthur J. Murton - Director, Office of Complex Financial Institutions, Federal Deposit Insurance Corporation (FDIC)
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