Squaring the circle of banking regulation and capital markets in Europe | AFME

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Squaring the circle of banking regulation and capital markets in Europe
17 Jan 2020
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Author Jacqueline Mills Managing Director
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Banks’ investment and trading activities are fundamental for the functioning of European capital markets. They assist governments, corporates and businesses to raise funds through the issuance of new securities and use their balance sheets to support these fund-raising activities by making secondary markets in the securities issued. This facilitates liquidity by lowering the borrowers’ initial funding costs in the process. Through their capital markets activities, banks also provide hedging solutions to a wide range of corporates and institutions, facilitating access to investment and saving opportunities across the globe which lowers risk through diversification.

Banks which provide these important services are often amongst the largest, internationally active ones, as these are the players with the scale and resources required to access global pools of capital. Such scale is also needed to invest in the infrastructure, technology, trading expertise and risk management skills required to conduct such activities efficiently and soundly.

Yet banks’ capital market capacity has decreased significantly since the crisis. As the EU prepares to reinvigorate its plans to develop the region’s capital markets via its Capital Markets Union (CMU) project, a closer look at how banks’ market intermediation and market-making functions are impacted by global regulatory initiatives will be key to ensuring the deepening of  market-based financing  in the EU. 

Banks have retreated from capital market activities - but does it matter?

In January last year, a report from the Committee on the Global Financial System (CGFS) examining structural changes to the banking system following the crisis, observed that global banks had shifted away from trading activities[1]. In April 2018, AFME and PwC issued a report looking at how the balance sheets of 13 banks, representing 70% of global capital markets activity, evolved between 2010 to 2016[2]. This study was able to quantify that these banks had reduced fixed income and equity assets by just under 40% during this period of post-crisis regulatory reform. Importantly, the study also looked at the reasons behind this reduction in capacity. It determined that changes to the prudential framework, and to risk-based capital requirements and the leverage ratio in particular, were responsible for about two-thirds of the explainable decline in capital market assets.

Changes to prudential regulation were of course not designed by policy makers to be neutral in terms of impact, but to balance the requirement to strengthen the financial position of banks and the financial system against the need to preserve effectively functioning markets. In this respect it is legitimate to ask whether banks’ capital market capacity may have shrunk too far. Along these lines, the question also arises as to whether the EU has a banking system which, in addition to supporting direct lending to the economy, can also help improve the size and depth of its capital markets in line with the ambitions of its policy makers?

At first glance, there may not be any visible cause for concern regarding the supply of financial services. Years of accommodative monetary policy have generally kept the cost of finance down and the non-bank sector, which operates without the same regulatory constraints that banks face, has stepped in to replace some of the capacity previously provided by banks. However, monetary policy and economic conditions can of course evolve, and the non-bank supply is untested and may not prove to be as resilient as that from banks in times of stress.

Global dealer banks have in the past been able to use their large inventories of securities to help mitigate market volatility. But with shrunken levels of such assets, will they be able to do so in the future?  The previously mentioned GCFS report also recorded worsening liquidity conditions in some market segments, particularly for assets which typically trade less frequently than others. Could this be an indication that banks are not able to provide liquidity as they were before, and that there are fewer alternatives for less frequently traded assets? Should we be concerned that banks’ post-crisis business model adjustments have given rise to capital market activities being increasingly concentrated in a smaller number of players, with European banks in particular having withdrawn from these businesses?

A moving target: evaluating reforms while implementing further regulatory change

More research needs to be done to answer these questions. Encouragingly, after a decade of regulatory reform, policy makers at both global and European levels have signalled they are shifting from rule-setting to monitoring and adjusting their reforms if necessary.

In principle, this approach bodes well for the development of EU capital markets. We are however faced with a sequencing issue. Regulatory reform is in practice not yet finished andthe last piece of the prudential puzzle, known as the final Basel 3 agreement, is still to be implemented. With this critical aspect of reform outstanding, it is extremely challenging for policy makers and industry alike to evaluate the consequences of the full regulatory package. This is especially true in the context of banks’ capital market activities where there are multiple interactions between different parts of the regulatory framework and where prudential and markets policy makers often appear to work in silos without reconciling their objectives.

In Europe, the process for implementing the final Basel 3 agreement will start with proposals from the European Commission for a 3rd Capital Requirements Regulation; possibly before summer next year. This will be followed by the usual negotiations between the European Parliament and Member States, which typically last two years. Therefore we are still a way off from knowing the final shape of the prudential framework and truly being able to assess how banks and their clients will ultimately be impacted. Especially in the context of depressed market valuations for European banks, uncertainty on the regulatory end-point is a significant challenge to manage and could lead to a further reduction in European capital markets capacity. It is therefore essential that this is carefully navigated.

What might Basel 3 mean for European capital markets?

A key feature of the final Basel 3 proposal is the so-called output floor, a measure designed to act as a backstop to capital requirements based on banks’ own estimates of risk weighted assets (RWAs). The output floor ensures that that internally modelled RWAs are not less than 72.5% of the corresponding amount calculated under standardised approaches for credit, operational and market risks. Contrary to previous rounds of regulatory reform where most market participants saw overall increases in capital requirements, the output floor is largely intended to capture outliers.  This means it will affect banks unevenly, depending on their use of internal models and their type of business. Given the distribution of internal model usage, it is not surprising that initial impact assessments by the Basel Committee and European Banking Authority (EBA) show the output floor is likely to affect larger banks more than smaller ones and European banks more than their US counterparts[3].

The EBA’s work also shows that 7 of the 8 European G-SIBs in the sample analysed will be bound by the output floor instead of capital based on internal measures of risk. This move away from a risk-sensitive capital framework is undesirable because when regulatory capital becomes increasingly separate from underlying risk levels, this can lead to sub-optimal capital allocation decisions within banks and investments in riskier assets, rather thana safer system overall.

Additionally, over recent years, many European banks have undertaken considerable efforts to improve their models under regulatory and supervisory programmes of the EBA and the European Central Bank (ECB) respectively. . It is understandable that the banks that have invested in these changes do not welcome the limitations the output floor places on the use of their models. Nevertheless, the output floor is a key part of the agreement reached between the members of the Basel Committee, and European authorities have repeatedly stressed their intention to implement it faithfully, placing a high weight on the importance of maintaining their credibility at the international negotiating table.

While the output floor is likely to lead to overall increases in capital requirements for European banks, the final Basel 3 package includes other changes which will specifically affect their capital market activities. For instance, the new rules for calculating capital requirements for trading activities (known as the Fundamental Review of the Trading Book (FRTB)), will result in higher capital levels for market risk than today and becoming binding under the Commission’s CRR3 proposal. Banks will also no longer be allowed to model credit valuation adjustment (CVA) risk which reflects losses arising from changes in the credit quality of a counterparty to a derivative contract.

Beyond the treatment of market risk, the final Basel 3 package also includes a new standardised approach for determining the capital that banks must set aside to deal with counterparty credit risk, or the risk of loss arising from a counterparty defaulting before it is able to meet its obligations under a derivative contract. Not only does this new approach intervene in the determination of the standardised output floor constraint, it is also relevant to several other areas of the prudential framework, leading to cumulative impacts on the availability and pricing of hedging solutions which have not yet been considered holistically by policy makers.

Given that risk weighted assets for market risk make up a relatively small fraction of European banks’ total RWAs on average, the potential effects of these changes could appear to be comparatively small. However, as capital market activities are largely undertaken by of a relatively small number of large firms, these banks will be much more impacted than the average. Appreciating the extent to which these banks’ market activities have already impacted as shown above, the final parts of prudential reform must be implemented with caution if Europe does want to see banks support the growth of its capital markets.

What should Europe do when implementing Basel 3?

It is well known that the global regulatory community struggled to reach a final agreement on the Basel 3 package, and it will be important for all jurisdictions to implement it consistently and within the spirit of the agreement. This will be particularly crucial for the parts of the proposals which relate to global market activities where banks compete internationally. At the same time, the EU recognises that some of its banks will be the most heavily impacted by the proposals. European legislators should therefore ensure that their implementation of does not go beyond the intended impacts of the international standards. For instance, the output floor needs to be implemented as a true backstop measure. This can be achieved by basing its calculation on Basel minimum or Pillar 1 requirements and internationally agreed capital buffers rather than also including European and bank specific requirements as has been suggested by the EBA. Additionally, as with all Basel requirements which are calibrated at the group level, it is important that the floor applies to banks at a consolidated level rather than individual entity level to ensure that it does not distort or unduly impact specific businesses.

It has already been stressed that that policy makers must reflect carefully on how the new changes to the prudential framework might further constrain banks’ market intermediation and trading activities. This should be done now, before the requirements are integrated into the rulebook. Without more joined up reflection between banking regulators, and those who wish to promote capital market development in Europe, there is the very real possibility that the reduction in capacity will continue. If this occurs, there is little hope that other CMU initiatives on their own can achieve the thriving capital markets Europe aims for and needs. The European economy will not benefit from the spare tyre function of having more developed market-based financing, nor it will it enjoy the much-needed private risk sharing and shock absorbing function that strong and integrated capital markets can bring.

Beyond Basel 3, European policymakers should also examine how bank and market-based finance can be better linked. For instance, by enabling banks to make greater use of securitisation. In an economy that has been diagnosed with overbanking, banks need to be able to shift assets into capital markets. Not only will this reduce risk on their balance sheets, freeing up capacity, it will also provide investors with access to otherwise illiquid exposures. However, for banks to be able to engage in such transactions they need to make economic sense. This will only be the case if the cost of transferring risk to the market is translated into a commensurate reduction of the regulatory capital charge of the securitised assets. Policymakers should therefore also consider whether the rules governing regulatory capital relief, when risk is transferred outside of the banking system via securitisation, need to be revisited. Here, supervisory authorities, and the ECB, as the supervisor of the largest Eurozone banks, also have a key role to play to ensure that these rules can be operationalised as smoothly as possible.

The new Commission and European legislators have a challenge to better integrate their approach to banking regulation and capital markets. By following the above recommendations, they can go a long way to building the capital markets Europe needs to retain a dynamic and sound economy.

This article first appeared in Revue Banque on 10 January 2020

[1]Structural changes in banking after the crisis, 24 January 2018, Committee on the Global Financial System

[2] Impact of Regulation on Banks’ Capital Markets Activities: An ex-post assessment, 12 April 2018, AFME & PwC

[3] Basel III Monitoring Report, March 2019, BCBS and Basel III reforms: impact study and key recommendations, 5 August 2019, EBA