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After the fall: regulatory heavy-lifting to build greater systemic resilience


by Phil Miall
Head of Credit Research & Strategy, QIC

The traumas of 2008/09 were the ‘never again’ moment for a generation of policymakers and regulators. A near-catastrophe once in a lifetime is enough. Preventing a repeat is the priority.  

Monetary policy has been lent on as the principle tool of macroeconomic stabilisation, with fiscal policy playing a secondary role. That, of course, has not been the end of the matter.

  • The distress of the financial system was so spectacular that legislatures, policymakers and regulators have responded with a burst of law and rulemaking. Regulators have the challenge of striking a balance between greater systemic resilience without resorting to the kind of heavy-handedness that could unduly hinder economic activity.

    The breadth of the regulatory endeavour is vast (Figure 1): higher risk-weighted capital requirements; tightening of risk weights; lower leverage; new measures for resolution; and structural reforms, including the ‘Volcker rule’ on proprietary trading in the US, the ringfencing of retail banking in the UK and reform of various regulatory institutions.

    Figure 1: Key regulations 

    It’s been noted that the most important regulatory result of the Great Depression in the US was the Glass-Steagall Act, which ran to 37 pages. This time, the Dodd-Frank Act ran to 848 pages and requires almost 400 pieces of detailed rulemaking by regulatory agencies. [1]

    Sceptics point to mountains of new rules, cost imposts and restrictions and question both their effectiveness and the danger of unintended consequences. Communities, however, might think that the trade-off is worthwhile if it does lead to a safer global financial system.

    As it is, the new rules do increase the safety buffer. We estimate that in real terms the safety buffer has increased as much as two to threefold for large banks in developed markets, as measured by metrics such as raising banks’ Common Equity Tier 1 capital ratio, Liquidity Coverage Ratio, as well as reduced leverage and the like.  

    While the number of changes and new rules are breathtaking, in substance and spirit they are not really radical: completely overturning the known financial world is not the aim. Rather, the motivation is to make global finance safer, more resilient and transparent.  

    Health check for European banks

    Those objectives are at the heart of the European Central Bank’s (ECB) three-stage asset quality review (AQR) (Figure 2) of 130 EU banks representing 85 per cent of system assets. Banks are expected to be notified of the results around 17 October followed by a public announcement around 28 October.

     Figure 2: ECB's assessment

    There’s a lot resting on the AQR. Initial stress tests in 2010 and 2011 failed to fully restore confidence in the European financial system. 

    Despite concerns about previous exercises, there are higher hopes that the ECB’s three-stage probe will lead to cleaning up the European banking system. It consists of an initial supervisory risk assessment to identify portfolios that need scrutiny; an ongoing AQR and the concluding stress tests, which provide a more complete picture of European banks’ health than previous tests.

    The most important aspect of the exercise will be the disclosure of comparable and consistent data and results across the EU.

    Currently, the ECB is still providing emergency credit due to the lack of trust between banks. Minimal transparency, language differences and differing accounting rules have led to widespread concern that some banks may be hiding bad assets and are undercapitalised.  Peripheral banks, in particular, are struggling under the weight of higher funding costs if they can access the market at all.

    The ECB is working closely with national regulators to align accounting standards, which are fragmented at best. Italian banks, for example have more conservative definitions of non-performing loans leading to higher reported non-performing loans, while in Spain some repossessed assets –  real estate, for instance – can be reclassified as performing assets.

    Once the assets have been uniformly defined and valued they will be subject to two stress tests – baseline and distressed. Under the baseline scenario, banks must achieve a minimum common equity tier 1 capital ratio of 8 per cent, while they have to be above 5.5 per cent under the more stressed scenario.

    After disclosure of ECB results, banks with a capital shortfall will have two weeks to come up with capital restoration plans. They will then have six months to cover any capital shortfall identified in the AQR under the baseline of the stress tests and nine months for those identified under the adverse scenario.

    Banks have been strengthening their balance sheets since July 2013. The ECB notes that more than €100 billion has already been raised and the market believes that any further capital requirement should be manageable.

    A recent Ernst & Young survey of European banks showed most are confident of the outcome, with only 8 per cent planning to raise capital after the AQR. [2] German banks are the most confident, while Spanish banks are the least confident.

    In our view, the review could highlight weaknesses in smaller regional banks, particularly those in Italy, Germany, Greece and Austria.

    However in the longer term, investors should be more confident that European banks have been assessed on a level playing field, that there has been credible independent oversight of the process and that those banks that pass the test are resilient and well capitalised.

    Australia not cocooned

    Though Australia’s big banks sailed through the GFC compared to the damage suffered by many global counterparts, the after-effects of those events and still somewhat elevated funding costs are being felt domestically.

    In the years before the GFC, there was a roughly 120 basis points spread between mortgage rates and the official cash rate (Figure 3). That’s widened to around a 250 basis points gap since 2008.

     Figure 3: Spread over cash rate

    There are a few explanations for this. Global finance is still gun-shy compared to the halcyon pre-GFC days and this is showing up in higher wholesale funding margins.

    This was initially felt during the sharpest phase of the GFC, but continued afterwards as Australian banks’ funding spreads rose further on the back of regulatory-driven deposit gathering.

    Furthermore, credit growth has been soft and well below pre-crisis levels. The upshot is that lenders have focused on preserving already-low margins (Figure 4) rather than competed for market share through excessive discounting.   

     Figure 4: Interest rate margin

    So despite a record low Australian cash rate, borrowers are paying up to 150 basis points more interest than they might in more ‘normal’ circumstances, according to our estimates.

    We don’t expect a change in the differential between mortgage rates and the cash rate any time soon. Banks will be very protective of their net interest margins and ROE and will only unwind if competition intensifies or if their funding costs ease further. While this is not imminent, conditions for a slow, partial unwind should eventuate.

    Safety first is in

    The recent history of the global financial system can be roughly divided into two periods; the ‘paradise’ of the go-go pre-GFC era and ‘the fall’ since the end of those days.

    The rising regulatory tide is irking banks and shareholders, but a more durable financial system should emerge from the changes, in our view.

    Banks should be stronger and able to trust one another more in crises. That would be a public and economic good. Still, despite best efforts and intentions, investors should prepare for the occasional market curve ball and unintended regulatory consequence.  

    [1] Martin Wolf Radical remedies in Australian Financial Review 5 September 2014
    [2] Ernst and Young European Banking Barometer – 1H14 http://www.ey.com/GL/en/Industries/Financial-Services/Banking—Capital-Markets/EY-european-banking-barometer-1H14


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