- 3. The alchemy of banks, the financial crisis and structural reform proposals
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- European banking : efficiency, technology and growth
- Determinants of Cross-Border Mergers in European Banking | SpringerLink
- Challenges for the European banking industry
Securities lending for shorting and generating collateralised levered transactions for asset managers were also part of the new system. The activities of re-hypothecation and re-use of securities in the repo market amplified the creation of chains of inside liquidity and high leverage with negative consequences when haircuts increased and the repo market turned illiquid as the crisis unfolded. The international financial regulatory reform has primarily focused on the banking system.
3. The alchemy of banks, the financial crisis and structural reform proposals
It has not yet dealt with these new activities in an appropriate way. A crucial rationale for bank regulation relates to the fact that when they concede credit, banks create money by creating a corresponding deposit. This activity that is at the centre or our credit-money system, involves a significant liquidity transformation as deposits are much more liquid than credits. I will examine some of them later. While not taking in deposits, non-bank entities forming the new financial sector should also be subject to some new regulations.
There is a need to address vulnerabilities created by the expansion of leveraged assets funded by short-term liabilities that play the same role as money. Chart 1 illustrates how banks have been decreasing their importance in the whole financial system in benefit of other institutions forming the new market-based credit system. In , total assets of banks in the euro area stood at EUR 33 trillion and declined to EUR 28 trillion at the end of last year. The expanded role of capital markets and the market-based credit system with the resulting shrinkage of the banking sector are not per se negative developments.
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Diversification and competition contribute to enhance efficiency and to lower transaction costs in the financing of the economy. Banks too have welcomed the embryonic initiatives of the EU Commission to develop a capital markets union in the future. As mentioned previously, banks also participate in the new forms of financing and the bigger ones are crucially involved in all the activities linked to capital markets, from the issuance to the distribution of securities and trading.
On the other hand, existing Investment Funds are often part of banking groups.
European banking : efficiency, technology and growth
However, despite adjustments in business models, more traditional banks face accrued challenges. Today, I will argue that banks are under siege but a successful adaptation to the challenges they face is key to revive their prospects and their effective contribution to credit intermediation. After all, one cannot ignore the importance of a stable, profitable and competitive banking sector for sustainable economic growth, even if it is bound to shrink.
In this lecture, I will first dwell upon the main challenges that banking activity faces in the world at large. I will then discuss some proposals that aim at a deep reform of the financial system, in view of the future role of banking. Beyond increased competition from non-banks, the banking sector faces competition from Financial Technology FinTech firms with other challenges relating to the low interest rate environment as well as the regulatory measures still to come.
There is a lot of hype around the emergence of new specialised start-up financial firms that take advantage of digitalisation and big data techniques aimed at unbundling the activities of banks. This is not foreseeable despite the current excitement. This is because banks will also adopt the new technologies and will defend their franchise. Furthermore, after crossing some thresholds, the new forms of finance will eventually start to be regulated due to the same market failures and externalities i.
Determinants of Cross-Border Mergers in European Banking | SpringerLink
Having said that, payment services could indeed become a domain where banks may lose significant market share. Other activities at stake comprise: savings and investment management over the internet, with robo-advisors that provide algorithm-based portfolio management services online at a fraction of the costs associated with traditional portfolio managers and investment advisors; crowdfunding or direct equity funding of projects by investors gathered mostly over the internet; peer-to-peer lending P2P whereby online services match lenders and borrowers which can be individuals or small businesses; or online money management advice aggregating all bank and savings accounts of the clients.
Hundreds, if not thousands of start-ups can be found in all of these domains. The whole sector is nevertheless still quite small. According to a recent study by McKinsey, USD 23 billion of venture capital and growth equity has been deployed to FinTechs in the five years to , with around one-half of this total invested in It is followed by P2P lending, which is the next most developed activity, funded by hedge funds, institutional investors and sometimes even banks. The first accidents with bad credits started to emerge recently as big data and smart algorithms can also fail.
As the sector expands, many more episodes will likely occur. Furthermore, if it starts to cater for regular retail funding it will gradually become regulated as a banking activity. Nevertheless, intensified competition from FinTech companies represents a potential threat for banks.
If they do not respond effectively to this challenge, this could lead to a loss of market share and significant reduction in bank revenue. The new technology of the distributed ledger or blockchain is of a different nature and represents an opportunity, mostly for banks that have financial capacity to invest in it, and can establish a wide network of secure, less expensive account transactions and settlements. Even that will not dispense with some central official role to ensure final settlement and validate the reputation and qualification of participant institutions in the network.
Private money like Bitcoin, behind the blockchain technology, cannot go far due to lack of confidence.
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Like many commercial banks, central banks are also actively studying possible developments in this area and attentive to their potential role in the future. On the regulatory side, many of the measures deriving from the post-crisis agenda are already in place: capital requirements were increased, fully-loaded Basel III requirements are already met by most banks , a leverage ratio was imposed, new liquidity rules were established.
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The Liquidity Coverage Ratio LCR which was implemented in the EU in October aims to ensure that banks have enough liquid assets to meet liquidity needs over the following 30 days. Moreover, the Net Stable Funding Ratio NSFR which will enter into force at a later stage but is already complied with by most euro area banks will require banks to replace short-term with longer term funding, which is generally more costly because of term premia.
The experience of the crisis has however demonstrated that some trade-off in profitability versus resilience is well justified. Importantly, a few remaining initiatives on the regulatory agenda for banks and the non-bank sector still need to be finalised and implemented.
A Quantitative Impact Study QIS is being conducted for the banks to report the consequences of the drafted measures and a final decision will be taken in Autumn, only after these consequences are assessed. The commitment is that there will be no Basel IV and that Basel III will be concluded by year-end thus providing regulatory certainty for the future. Another ongoing discussion that has added to regulatory uncertainty concerns the treatment of sovereign exposures.
This discussion is important and could indeed have a significant impact on the financial sector. The ongoing MREL regulatory preparations, in parallel with TLAC implementation, will be key to ensure a consistent approach towards loss absorbing capacity. The preliminary announcements to the industry and a possible interpretation of the Delegated Regulation recently published by the EU Commission, has led to estimates of MREL eligible liabilities by market analysts that would imply new subordinated debt issuance needs in the order of EUR bn.
The whole set of issues related to MREL have to be addressed with great care, as very high, new requirements of subordinated debt or capital would not easily be absorbed in present market conditions and would therefore lead to financial stability concerns. Ultimately, the level of MREL required for a bank should depend on how it is planned to be resolved.
They are separate requirements, which serve different purposes, and therefore also have different scopes. Beyond the structural trends and regulatory developments described earlier, the current low interest rate environment, at global level, also poses important challenges for the banking sector. To understand why interest rates are so low, it is useful to refer to the concept of an equilibrium or neutral real interest rate. The importance of this concept is that it provides a sort of anchor to a monetary economy, implying that monetary policy needs to shadow the real equilibrium rate in order to meet its price stability mandate.
When applying different model-based methods to estimate the real equilibrium rate for the euro area, it emerges that, in comparison to pre-crisis years, estimates of the equilibrium real rate have sharply declined during the crisis and have continued on a declining trend and are now in negative territory, as is the case for the U.
If the real equilibrium rate is decreasing then failure of monetary policy to accompany the downward trend would leave the economy with too high borrowing costs with respect to the return on investment. In turn, this would discourage investment and consumption and generate recessionary and deflationary pressures. The regulatory reforms for the banking sector are contributing to a shift of activity and the emergence of new players in the non-banking space, which in turn is leading to tougher competition in areas traditionally dominated by banks.
To ensure a level playing field and to contain the emergence of new risks beyond banking, we need to continue our efforts to establish a comprehensive regulatory framework for non-banks and market-based activities. In my view, while we have improved our understanding of the risks in this part of the financial system, there is still significant work ahead of us to overcome the potential weaknesses in the regulation of entities and activities in this sector.
Let me mention two areas where important efforts are currently underway.
First, at the global level, the Financial Stability Board FSB has just published its consultation paper on addressing structural vulnerabilities in the asset management sector. The paper lays out various recommendations that aim at strengthening the resilience of asset management and investment funds.
This new regime will cover a significant number of non-bank entities providing investment services. As recommended in the EBA report of December , the regime is expected to have three tiers, aiming at introducing risk-sensitivity and proportionality. Another important aspect in dealing with the risk stemming from shadow banking activities relates to the introduction of macroprudential margins and haircuts in SFTs, including repos, as well as in OTC Derivatives transactions.
Challenges for the European banking industry
These tools would reach beyond the banking system and also address the build-up of leverage and liquidity risks in parts of the financial system, where we have seen rapid growth in recent years. Macroprudential authorities should have the power to set margins and haircuts. Margins and haircuts are a determinant of the build-up of leverage via derivatives and SFTs, and are strongly interlinked with the procyclicality of that leverage. For derivatives, the initial margin determines the amount of exposure that can be created for a given amount of equity.
In turn, the size of the haircut on SFT collateral, particularly in repos, determines the amount of funding market players can obtain for a given amount of collateral. In exuberant times, low volatility and risk-aversion as well as competitive pressure lead to low margins and haircuts, supporting the build-up of leverage. When the cycle turns, higher volatility and higher risk aversion feed into higher margins and haircuts, amplifying de-leveraging pressures.
As a result, a vicious cycle can emerge, where higher margins and haircuts force de-leveraging and more sales, generating a liquidity spiral.