Saturday, November 6, 2010

Economics 6/11/10: Regulation in Financial Services Sector

This an unedited version of my column in the current issue of Business & Finance magazine.

The New Regulatory Normal: banking and financial services future

The latest poll of public opinion on the issues of domestic and cross-border competition, released in late October, has found that citizens across the EU identified energy (44%), the pharmaceutical products (25%) and telecommunication (21%) as the main sectors where they perceive lack of competition to remain a major problem. Irony has it, banking and financial services (18% concerned) came out closer to the bottom of the list in terms of perceived competition deficit.

Even though m
ore than a quarter of Greek (31%), Irish (28%) and British (27%) residents said that, based on their own experiences, a lack of competition was causing problems for consumers in the financial services sector, these proportions are still below those for other sectors. For example 30% of Irish respondents are concerned with lack of competition in transport sector, and 41% in pharmaceutical sector.

This is despite the fact that across the EU, and indeed the entire developed world, banks are being supported directly (via taxpayers’ financed measures) and indirectly (via the Central Banks supply of liquidity) to the extent well in excess of the combined subsidies delivered to all of the aforementioned sectors of concern. Writedowns of banks assets remain a top priority for policymakers and the adverse newsflow from the sector is abating extremely slowly (chart below).

Total asset write downs by category, October 2009–April 2010

$ billions, Revisions to estimates

Source: IMF GFSR database, 2010

In addition, banks and financial services companies are facing a tsunami of regulatory reforms, which dominate the newsflow and will likely result in more restricted competition and lending in the sector in years ahead.

Banks and financial services companies across the EU play by far much more dominant role in financing economic activity of firms and households than they do elsewhere in the world, as was highlighted in the latest Global Financial Stability Report from the IMF. In contrast with consumers, business leaders worldwide perceive the financial services to be the current hot spot for adverse pressures on the economy. Banks and financial services providers are expected to be more significantly impacted by the uncertainty induced by the policymakers responses to the crisis. For example, Global CEO Study, 2010 conducted by the Institute for Business Value, IBM shows that a large number of CEOs worldwide expect the Banking and Financial Services sector to be subject to greater structural change and volatility over time than the public sector, despite the fact that public sector itself is experiencing unprecedented debt and deficit pressures.

So the latest public opinion polls seem to be at odds with the reality of the potential crisis-and reforms-induced distortions to competition in the banking sector.

This is an unfortunate oversight, for today, more than ever before financial services need a serious debate about the role for and the future direction of regulatory and supervisory regimes in the sector.

egulatory structures in the traditional banking and financial services sector have failed to keep up with the increasing complexity, demand for services and interdependence of products and service providers. At the heart of the current crisis, by all accounts, were the imbedded conflicts of interest and outdated regulatory regimes.

For example, the overreliance on prescriptive regulation, an approach that is now being promoted as the panacea to the future crises, is itself partially to be blamed for the meltdown in the rated instruments. Per IBM research paper “The yin yang of financial reform: Embracing maxims to enable financial stability and healthy financial innovation”, when regulations mandated that institutions use of the credit rating agencies to assess risks inherent in MBSs and CDOs, “internal credit research essentially died. Had institutions done their own credit analyses, perhaps the ultimate outcome would have been different or, at the very least, less severe.”

This points to a major potential pitfall in the ongoing process of increasing regulatory systems reliance on prescriptive rules as a protection against future crises.

Since the Lehman collapse, governments in the US and Europe have been addressing the imbalances in their national financial systems by passing both structural and operational reforms. These focus on size, scope, societal costs and “too big to fail” institutions (i.e., cross-firm reforms). Operational reforms, typically implemented by regulators or multilateral international organizations, focus on capital, liquidity, incentives and taxation (i.e., what firms need to do within their own organizations).

As our research at the
IBM’s Global Centre for Economic Development (GCED) highlights, on a nutshell, the direction of reforms adopted by the US and EU legislators to-date can be described by a stylized formula measuring the returns on equity (ROE) in the banking sector. So far, new regulatory regimes being introduced imply that in the future banking sector will see “Lower R + Higher E = Lower ROE”. This is a structural threat to the viability of the sector, and many new regulations coming on-line globally are the main culprit.

From the international Basel III framework to the Dodd-Frank Act in the US, increased quality and quantity of capital reserves on the financial services companies is likely to drive down global credit supply both in the short term (as banks engage in rebuilding their balancesheets) and in the long run (as financial services providers compete for a severely reduced capital pool).Per Josef Ackermann, the Deutsche Bank CEO, “There can be no doubt that [Basel III] will produce a drag on economic recovery.”

This statement relates to the core headlines coming out of Basel III and to the auxiliary parts of the framework. Specifically, higher capital reserves under Basel III, increasing common equity capital to 4.5% of risk-weighted assets by 2015 and to 7% by 2019, are expected to cost global economy some 3.1% of overall worldwide income over 2011-2015, implying a loss of almost 10 million jobs worldwide.

Ratio of capital to risk weighted assets held on balance sheet

% of Assets

Source: World Bank Financial Stability Indicators

In addition to the cost of rising capital reserves, Basel reforms include the idea of imposing a tax on the systemically important (aka larger) institutions, known as SIFIs. In addition to amounting to a tax on consumers (especially in the markets where a small number of larger banks controls the market for services, such as the Euro zone), such a charge will not address the issues of product (rather than institutions) specific risks.

Finally, Basel III introduction of the new liquidity and funding rules offers another example of a potentially market-restricting intervention that can end up costing the sector dearly, while producing little real benefit in alleviating systemic risks. The idea behind these measures is to ensure that financial institutions hold sufficient liquid reserves buffers to withstand a bank run, as well as to reduce the banks over-reliance (especially in Europe) on short-term wholesale funding. At the very best, these measures will lead to a significant cut in the banks’ ability to generate credit in the future.

At the same time, it is highly doubtful that any level and quality of reserves can ever guarantee a sufficient insurance against significant asset busts or even large liquidity events. Past history, as for example, analysed by a recent research paper from the University of Pennsylvania, clearly shows that regulatory tightening following previous episodes of major financial markets corrections had inevitably failed to prevent or even to significantly alleviate future financial busts. Instead, every episode of deep markets corrections was followed by severe tightening of financial regulation, prompting lenders to increase their reliance on more complex financial products. The levels of reserves never once were found sufficient to cover the sector.

More specific potential adverse effects of Basel III and Dodd-Frank Wall Street Reform and Consumer Protection Act changes relate to all three core sides of financial services business models: the trading side, the capital side and the funding side. On the trading side, increased capital reserves will likely constrain trading exposures, and cover for securitization and counterparties. The positive here will be a shift from narrowly traded derivatives to exchange-traded and centrally cleared derivatives. The net effect, however, will be smaller new products base in the sector and tighter margins, leading to a pressure on the returns.

Another study, titled “Global financial services: a New Regulatory Normal” prepared by the GCED identified a series of other potential risks in the latest regulatory reforms processes worldwide. In addition to the main headlines on capital side of the reforms outlined earlier, ongoing regulatory changes imply introduction of pro-cyclical capital bases, tighter restriction of capital allowances to paid up capital and retained earnings, elimination of hybrid products from capital base, as well as deferred taxes and intangibles. Restriction of minority equity and leverage ratios alongside with aforementioned capital rules changes will also likely lead to higher cost of banks capital and origination bases, implying restricted lending and associated jobs and income losses in the real economy. Lastly, stressed liability-linked liquidity provisions and efforts to reduce maturity mismatch via reduced reliance on short-term funding will further depress lending.

All of this suggests that going forward, banking sector in Europe and the US will face significant difficulties in generating new lending. In line with this, financial services growth is likely to shift away from traditional banking and brokerage, and toward less regulated and liquidity-rich sovereign wealth players and alternative lenders and investors.

This, in turn, will have profound effects on economic development, as the aforementioned GCED research highlights. In addition to tighter credit markets for companies and households, new rules are likely to lead to significant increases in costs and access barriers to capital for long term assets, such as infrastructure and plant investment. This development can also amplify, not reduce, the links between the exchequers and the banks. As banks will play an increasingly important role as the holders of public debt and as the source of tax revenue, current liquidity traps will be deepened. Liquidity supply and velocity of money will be reduced and M2 and broader money supply metrics will continue to lag liquidity injections from the central banks.

The resulting risk of closer political and economic integration between the financial services providers and the states can create simultaneously a new layer of inefficiency in financing of economic growth. It can also amplify shared risks, setting up the next crisis, this time around – with potential for a full contagion from the financial services to the sovereigns.

In the light of these regulatory changes and the convergence of regulatory regimes, banking and other financial services institutions face the need to provide sufficient internal buffers against the rising regulatory risk. These buffers require service providers to:
  1. Rethink their business models to simplify operations and enhance ability to deal with systems and models complexity
  2. Rebuild their balance sheet and focus on the new capital and leverage requirements
  3. Actively pursue opportunities for mergers and divestitures
  4. Improve their understanding of clients’ behaviors and preferences
  5. Reconnect with their clients by investing in client analytics to gain insights
  6. Provide clients with more and more complex and better responding services and data
In short, addressing business challenges presented by the ongoing processes of regulatory reforms worldwide, the banking and financial services sector will have to get much smarter in structuring future strategies for growth and operational processes.

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