Risky business

Western regulators have been cobbling together strategies to prevent a repeat disaster of the global financial crisis, setting out new demands on the banking sector. The success of such schemes is questionable, not least in Europe, where rules are killing off profitable business and driving borrowers into the arms of shadow lending institutions.

The tribal nature of the way institutions strategise and finally act, particularly at times of great crises, rarely seems to change. Past events inform current reasoning, which leads to future courses of action that seem perfectly rational.

Sometimes this approach works. On other occasions it fails, for reasons that only become painfully clear in hindsight. For proof of this, take the various fumbles, failures and grand compromises suffered and sought in recent years by Western regulators, in an often-times vain effort to get their financial sectors back on track.

Europe, here, is the classic example of muddled thinking and half-measures. In 2010, financial and political leaders formed the Committee of European Banking Supervisors, a feeble regulator vested with carrying out a round of stress tests to stabilise the eurozone’s banking sector.

Heavily politicised and lacking heft and fire-power, it hobbled from the start. After handing a clean bill of health to Belgian lender Dexia, only to see it shuttered a month later, it suffered the double humiliation of being replaced by the European Banking Authority.

The EBA fared little better, overseeing a much-mocked second round of stress tests little more than a year later. In July 2014, a report from the European Court of Auditors slammed the EBA for having “neither the staff nor the necessary mandate” to complete the task at hand. To Europe’s insulated regulators, unaccustomed to direct criticism, such words must have stung.

But the false starts offered belated benefits to legislators in Brussels as well as Frankfurt, home of the European Central Bank, the institution vested with implementing, in October 2014, a third (and, hopefully, final) set of banking stress tests. Slowly, almost vestigially, the Old Continent has learnt.

European stress tests may have been rightly ridiculed in the past for not being tough enough – even Klaus Regling, head of the eurozone’s rescue fund, admitted in April 2014 that they were “not very convincing”. Yet they did allow legislators to build a base camp before pondering new questions. Such as how much capital would banks need to get through the next crisis – and if they fell short of the magic number, should they raise more, or close down business lines? Or what level of liquidity should they have? Most importantly, what steps should national and regional regulators take when facing the need to bail out a struggling lender?

Prickly policies

Capital is perhaps the thorniest issue. How much does a bank really need? The minimum capital adequacy ratio demanded by the ECB is 8%, but it can fine any lender deemed unable to survive economic and financial shocks. A flurry of debt sales by European banks over the past 12 months was pre-emptively designed to assuage the new regulator, with lenders issuing everything from additional Tier 1 bonds to contingent capital bonds.

Yet what should a lender’s enlarged capital buffer set out to achieve?

Regulators, said Jan Putnis, head of Slaughter and May’s financial regulation practice in London, “will tell you that increased capital requirements are there in case a bank gets into trouble”. In reality, he said, it provides a far more useful service, by making “a bank think twice about booking more risky business than it should by requiring it to allocate capital to that business. Capital requirements are there for a crisis but they are also there to restrict banks from doing risky things in the first place.”

Increased liquidity, underscored and strengthened by consecutive Basel committees, has also had a major impact on lenders, with banks required to hold a buffer of “liquid assets” large enough to weather a 30-day financial storm. This is a more nebulous set of regulations whose long-term impact is hard to define, given that its success depends on endless variables such as, say, how fast people might seek to move retail deposits in a given extreme scenario.

Level of bailouts

Another question involves the level of desire among regulators to bail out struggling or errant lenders. In theory, the formation of a stable financial system should obviate the need for expensive, taxpayer-funded bailouts. But does this work in principle? Europe huffs and puffs about the long-term danger of soaking up public funds to pay for private bank bailouts. Yet during summer 2014, Brussels agreed to a scheme to protect creditors of Banco Espirito Santo, bailing out depositors and senior bondholders.

Such actions make it hard to imagine a future fully free of the bailout. One of the key challenges is how to assess general risk, and more specifically, whether a single, diseased lender can infect a national, regional or even global financial system, as Lehman Brothers did in 2008.

Slaughter & May’s Putnis wonders if we will ever succeed in measuring risk, and frets that “the accuracy of risk assessment and measurement has not improved much since the financial crisis. [T]here is no such thing as an entirely ‘safe’ bank. Banking – and there has been much misleading commentary on this post-financial crisis – carries inherent risks that should be recognised and controlled rather than wished away.”

Europe vs US

It’s easy to forget, too, that the developed world took two essentially divergent approaches to banking bailouts. True to its intrinsic nature, having learnt the hard way the importance of nipping recessions in the bud, the US opted, post-financial crisis, to force domestic lenders to swallow bailout capital. The net result was better banks that returned their public funding with interest.

In Europe, many nationalised lenders remain under water, a continued drag on the taxpayer. Nor has an ingrained tendency in Brussels to, in the words of one banking analyst, “assume that whatever decision they make is the correct one”, helped much. It engendered a sanguine post-crisis assumption that the region’s lenders were healthy enough, and that financial sector contagion was largely limited to Britain and the US.

Contrast that to the rapid, decisive, and successful actions of America’s Federal Deposit Insurance Corporation, which boasts long experience, said Putnis, in “resolving mostly relatively small banks that get into difficulty and cannot recover” – and in achieving that without causing more widespread contagion.

Double-edged solutions

One universal financial problem, yet to be adequately resolved by anyone, persists: that of how to resolve the collapse of a big cross-border lender.

“We are some way short of being able to say that the collapse of a big cross-border bank will not cause jitters and turbulence across the world,” a senior official at a major New York-based lender told IFR.

Even US regulators do not have all the answers. In early August, the FDIC and the Federal Reserve Board said they were “not convinced” by the contingency plans of 11 big American banks, none of which had demonstrated that it could be shuttered without disrupting the wider financial system. Former FDIC chairman Sheila Bair accused the independent agency of sending out “mixed messages”.

Curiously, the harder that regulators strive to impart trust in commercial lenders, the more elusive it becomes. The balance sheets of eurozone lenders may look increasingly “investible” from a credit perspective. But legal risk has started to replace credit risk, with banks forced to stump up billions of dollars to settle fines relating to everything from mortgage mis-selling to sanction busting. Others complain about the sheer weight of regulation now pressing on lenders.

“To an extent,” said Christian Schulz, senior economist at Berenberg Bank, “there is a danger in moving too fast with new regulations to restrict their operations. Banks are still in a precarious situation. Though that doesn’t mean you have to postpone the imposition of new rules forever.”

Meanwhile, new rules have reined in investment banks, killing off once highly profitable business models. Enforced transparency makes it easier for niche financial service providers to offer the sort of advice and data once the remit of universal banks. Squeezed margins force lenders from areas such as foreign exchange, hedging, and even equity trading, once the beating heart of investment banking, forcing them to focus on core skills such as wealth management.

As investment banks slim down, borrowers look elsewhere for funding, notably to the shadow lending institutions springing up. These non-bank financial intermediaries provide lending facilities, but unlike commercial banks, do not take deposits. That allows them to operate virtually unregulated in some countries, thereby slashing compliance costs.

Regulators “have cottoned on to this, and these non-bank lenders will inevitably slowly become more regulated”, said Putnis. But with so many shadow lenders based offshore, the process of drawing up and then enforcing new rules will be long and slow.