Time to row back on bank regulation?

"I had a discussion with a very senior regulator recently who told me: ‘Look, I know we’ve gone too far too fast on some of this and that we’ve made some errors, but I’m afraid I don’t know how to stop this process’. Now that’s quite scary."

That’s quite an understatement from a senior banker, who spoke to Euromoney but asked not to be identified. But it speaks to a new crisis facing the global financial markets: the relationship between banks and their regulators is increasingly strained. And that is in large part because the regulators simply can’t agree with each other.

The banker continues: "Remember that regulators and supervisors do not speak with one voice and nor do they all share the same attitude. Some are still in the mood to be very tough on regulating the banks and to proceed as quickly as possible. Others are growing increasingly afraid that the much talked about unintended consequences may be upon us. It is hard to say right now which group is going to win that battle of opinion."

It’s a vital battle at a critical point. The uncertainty is killing not just banks, particularly in Europe, but their fragile economies as well.

At Davos in late January, Michel Barnier, European commissioner for internal market and services and a driving force behind the re-regulation of the European banking and financial system, struck a conciliatory note over one of the key remaining steps to be taken: establishing resolution mechanisms for failing banks that would see bank bondholders taking losses rather than being protected by taxpayers.

This has been a key call in the reform agenda across countries worst hit by the banking system crisis of 2007-09. Never again should taxpayers pick up the bill for saving failing banks.

While it is eminently sensible that bondholders should take their lumps for providing credit to poorly run and excessively risky banks, the public consultation over the proposed European framework for managing bank crises appeared to contribute to a destabilization of the bank funding market last year.

Bondholders, mistrustful of the procedure for being bailed in at the whim of a regulator and fearful at a time when all banks were sitting on potentially life-threatening exposures on the very sovereign bonds these same regulators had required them to accumulate in their liquidity buffers, rebelled. They simply stopped buying bank debt. The banking system trembled. Starved of market funding, banks quickly began to de-lever, selling assets and not renewing positions that had been funded in the wholesale markets.

As the New Year dawned, only the European Central Bank’s provision of unlimited three-year liquidity against a wide range of dubious collateral prevented the banking system in Europe collapsing.

Now, as markets grappled with the protracted negotiations over a second Greek bailout that does little to restore that country’s finances to sustainability and took fright at potential contagion to other sovereign bond markets threatening more European banks, Barnier conceded the time was not right to press ahead with the bail-in legislation amid such uncertainty. The outline was ready, but implementation would be delayed at least while the Greek crisis played out.

At the same time, it became clear that regulators were re-examining the definitions of liquid and secure instruments that banks must hold in their liquidity buffers, so potentially allowing a reduction in their concentrated exposure to sovereign debtors with possibly unsustainable finances. Instead, other instruments might be allowed in liquidity buffers, including – whisper it – asset-backed securities which, away from sub-prime mortgages, have performed well.

Huw Van Steenis, banks analyst at Morgan Stanley, returned from Davos hopeful that even if bank regulators are showing no appetite for forbearance on higher capital requirements, they might soften their demands on banks elsewhere. He notes: "If there will be a long-term rethink it will be about liquidity ratios, where assessment of what should be in the liquidity buffers is likely to be widened. The eurozone sovereign crisis has caught regulators off guard and we think covered bonds will be included. We also think the haircuts on corporate deposits in the net stable funding ratio, which we see as poorly calibrated, may also get reviewed."

At the start of February, the ECB confirmed a renewed tightening of bank lending conditions in December 2011 and January 2012 in a survey completed after the first three-year Long-Term Refinancing Operation. With banks blaming higher costs of funding, reduced access to market liquidity and balance sheet constraints as well as the continuing euro area sovereign debt crisis and poor macroeconomic outlook, it seemed a turning point might be approaching.

For a moment, it appeared that banking regulators might be ready to pause, reflect on the substantial progress they have already made in forcing banks to increase capital and reduce risk, and consider if pressing ahead with re-regulation of the banks now might risk becoming far too pro-cyclical a policy amid a renewed economic downturn characterized by fiscal austerity, bank deleveraging and an interminable sovereign debt crisis.

"We are hopeful that something might be done at the very least on the net stable funding ratio because it appears to punish maturity transformation when that is at the core of what banks are supposed to do," says one banker.

Wise heads in the banking industry are encouraging such an approach, even though they know that any plea for leniency from bankers is likely to invite at best cynical dismissal, at worst open hostility from regulators and politicians.

Douglas Flint, chairman of HSBC, and, for all his vested interests, one of the most reasonable of commentators on the regulatory debate, summed up how far re-regulation has come and how far remains to go in a speech in London last month. Flint points out that for banks and regulators: "to deliver a workable solution – without unintended consequences – has been one of the greatest management challenges our industry has faced and one where strains are now beginning to show as policy design moves towards practical implementation."

On the plus side, banks have built loss absorption and made progress to better calibrate risk, and regulators have taken steps to better identify systemic risk and develop tools to handle it. However, Flint points out: "We have done a great deal to discourage that which we don’t want to recur – but have done less to define what we want the system to look like once we are finished with reform."

He asks some of the nagging questions. "Is the aggregate of all the measures, both complete and in train, duplicative or reinforcing? Is there coherence between banking, insurance, pension fund and asset management regulation?" Flint says: "Think about the much greater emphasis on long-term funding and liquidity in banking regulation, yet the greater restrictions on insurance companies holding longer-term debt in the Solvency II Directive."

And he highlights the inherent inconsistencies from multiple objectives now being demanded of the banking and financial system.

"We want stability as well as growth, we promote economic growth as well as fiscal austerity. We want banks to lend more and also grow capital both in absolute and ratio terms. We want the banking system to raise more capital while restricting its activities and restraining dividends. We want to see more competition in financial services but we don’t want to see the higher returns that would attract external private capital. We continue to incentivize the banking system to lend ever more to governments and then seek to stress test what happens if the same governments don’t or can’t pay." This last inconsistency has particularly irritated banks in Europe where supervisors have tried and failed several times now to copy the happy American trick of devising a stress test that restores confidence among providers of capital to the banking system by demanding banks take tough but achievable steps to rebuild balance sheets.

The European Banking Authority stress test carried out in December last year required European banks to come up with plans to raise €114.7 billion of capital by June this year, so as to create a capital buffer to 9% after stress testing for losses on sovereign bonds – yes, the very sovereign bonds regulators had told the banks to store up in their liquidity buffers.

Banks had to do this when both the funding markets and the equity capital markets were closed to them. UniCredit got a large rights issue completed in January only after wrenching volatility in its own share price which showed how tough the markets are to access even for national champions.

By the time banks submitted their plans in January, they had come up with a ragbag of measures including estimates for future retained earnings, dividends paid in shares, conversion of certain hybrid instruments into equity, liability management exercises to buy back and capture the wide discounts in various classes of their subordinated debt, and reduction and re-calculation of risk-weighted assets.

Only a small amount of actual new equity would be raised. Nonetheless the EBA quickly blessed these plans last month, with the caveat that a full assessment of their viability is still needed. The EBA lumped together the retained earnings from 2011, scrip dividends and new capital raisings to account for 26% of the amount raised and then added in retained earnings for the first half of 2012, conversion of hybrids and issues of new CoCos to take what it calls "capital measures" to 77% of the total to be raised.

It even claimed that most of the risk-weighted asset reductions came from disposals mandated by regulators to compensate for state aid and that its stress test has only required reduced lending to the real economy equivalent to 1% of the total amount raised.

This looks very much like a regulatory body desperate to avoid blame for preventing banks from lending to the real economy, even as central bank surveys show clear signs of reduced availability and higher cost of credit and banks separately announce substantial plans to deleverage heavily in the years ahead.

Suddenly governments are calling for growth as well as austerity and they can’t help but assume bank lending is important to this, even though banks themselves report that appetite to borrow is severely restricted among creditworthy corporates.

Regulators that were too lax on the way into the banking crash in 2007-09 must sense the coming wave of criticism for being too restrictive in the aftermath. "You ask me are they at risk of becoming somewhat pro-cyclical?" fumes one backer. "I would say that they have nipped a recovery in the bud."

Jamie Dimon, chief executive of JPMorgan, was in Berlin before the bank’s fourth-quarter 2011 results announcement in January and he reports that in Europe. "It’s quite clear that regulatory policy, government policy, central bank policy, is not coordinated and it’s making the situation worse, not better."

Does the EBA’s relaxed waving through of banks’ plans to raise capital, which include very little by the way of actual capital-raising, show regulators suddenly on the back foot?

Maybe it does, but bankers would be fooling themselves if they put much hope in any wholesale easing of the regulatory pressure.

Khalid Krim, managing director at Morgan Stanley who runs European capital solutions, says: "Is there the political will to move ahead with legislation to enact all the capital and liquidity requirements and bail-in holders of bank hybrid tier 1, tier 2 and potentially up to senior bonds? Yes there is. Do regulators think what they’ve agreed on Basle III should be revisited? No they don’t. They believe that they were right and should continue, but I believe that they will also be pragmatic and if final implementation requires tweaks and amendments to be made so that it works and achieves the objective, then we should trust that regulators will make the right decision.

"For instance, I can now see some regulators, given the sheer amount of new regulation and sheer number of changes, starting to ask for some pause before further legislation is added to test the benefits and costs of what has already been enacted. There is also a question about implementing Basle III in Europe next January. This may be sooner than the timetable for banks in US, Asia and other emerging markets, and could lead to an uneven playing field disadvantaging European banks."

Pausing and looking at worked examples might make sense.

Tim Skeet, managing director of FIG DCM at RBS, recalls chairing a panel at a Euromoney seminar on the Basle III rules last April, alongside Louise Mogensen, head of the financial affairs divisions of the Danish Ministry of Economic & Business Affairs. Denmark had suffered a real estate bubble centred on Copenhagen that had brought down one of the country’s smaller banks, Amagerbanken, which had been resolved under new procedures, which, for the first time, bailed in senior bondholders who took a 41% hit. Here, suggested Mogensen, was a real example of how bail-in could work in practice and she urged other European authorities to move ahead quickly with similar bank resolution frameworks.

Innocently, Skeet asked if any other Danish bankers in the audience had any thoughts on the matter. A bunch of hands shot up and, one after another, heads of borrowing from various Danish mortgage banks reported how they had been shut out of the wholesale funding markets following Amagerbanken’s bail-in, to the point where only the biggest bank in Denmark could access the bond markets.

Skeet says: "It’s interesting, isn’t it, that in the most recent bank problem in Denmark [in January 2012, struggling Vestjysk Bank and Aarhus Lokalbank were allowed to merge and benefit from state guarantees on their debt], losses were not forced onto bank bondholders. It seems that the Danish authorities learned a lesson when senior funding fell off a cliff after bail-ins on earlier bankruptcies. And now we see Nykredit and, more recently, national champion Danske able to do two-year senior unsecured deals that bond investors were willing to support partly at least because Denmark has devised a new bankruptcy package that avoids bail-ins."

It is an unfortunate feature of the debate over appropriate regulation of the banking industry that it has played out against a background of popular demonization of bankers. That simplistic narrative that blames all economic woes on greedy bankers might be welcome to politicians and regulators who can avoid blame for their own failures, but it doesn’t make for an informed debate. If the instinct of policy-makers is always to disbelieve what bankers tell them and to fear being derided for regulatory capture, they may be less inclined to correct a well-intentioned regulatory step that produces a bad outcome.

In the UK, the atmosphere has grown quite poisonous. The UK government abandoned the chief executive of RBS, a man recruited to clear up other people’s mess, when the bank’s board dared to grant him a portion of the pay due under a compensation plan voted through by shareholders including the government itself.

Many UK bankers are still bridling at a widely reported speech by Robert Jenkins, a member of the financial policy committee of the Bank of England, last November in which he accused those who responded to reduced availability and higher cost of capital and funding by reducing their lending to the real economy of indulging in a lobbying tactic against prudential regulation that is "intellectually dishonest and potentially damaging".

Bankers’ social standing and reputation has been so damaged by the financial crisis that probably only journalists are more despised. So it’s still interesting to see what exception they take to being branded liars. Nor do they accept the lectures from various figures at the Bank of England, from governor Mervyn King on down, that they can easily withhold dividends from shareholders and still raise more equity capital rather than reduce assets.

Again, as with the EBA’s blessing of European banks’ weedy capital-raising efforts, the Bank of England seems more intent on avoiding any blame for the consequences of higher regulatory burdens on banks than it is interested in adjusting the balance of regulation between stability and promoting lending.

In a note last month, UBS bank equity analysts Alastair Ryan and John-Paul Crutchley suggested that hostile regulation is undermining investors’ confidence in UK banks.

"As the well-capitalized, liquid, well-funded UK banking system continues to shrink, taking economic growth with it, the authorities are disclaiming ever-louder their role in this outcome. One Monetary Policy Committee (MPC) member wondered whether the problem, in part, was that bankers had become ‘reluctant, risk-averse jerks’. The Bank of England governor has suggested it is predominantly the euro crisis. The Financial Policy Committee (FPC) has pointed to banks’ dividend and bonus payouts as the culprits. We don’t believe these address the heart of the problem."

They continue: "All the listed UK banks could be compliant with all the announced regulatory requirements while growing lending and paying dividends. But, the ever-expanding regulatory agenda must be met with a banking system behaving as if current requirements will be raised. We believe the UK banks would be lending more, and funding more cheaply, if they and their share- and bondholders had confidence that today’s agenda was substantially complete."

While the UBS analysts suggest that "one would reasonably expect signs of impending forbearance to be evident" by now, in reviewing recent speeches from UK regulators, "only an inveterate optimist could see any signs thus far".

They note hints that the Bank of England might impose an even more conservative leverage ratio than previously discussed and concerns that UK banks cannot be certain that the required ratio of permanent loss-absorbing capital has reached its maximum among others. The equity analysts also point out that paying dividends to shareholders is not so easily abandoned by companies trading below book value with limited prospects of earnings growth. While BofE’s Jenkins accuses them of malignly raising the return on equity metric as a key to performance-related pay, the UBS analysts point out: "Pension funds cannot own a security with no yield, no growth and no prospects of either. Rather than recapitalizing the banking system, the rational shareholder demand is now for it to be decapitalized. This expectation by the owners of the companies is a key determinant of the banks’ behaviours. But, the pressure [from the Bank of England] for further capital remains."

There are many questions that still remain to be answered on the future shape of regulation across Europe. How will cross-border resolution work in practice? If bondholders see a system that provides greater systemic stability and reasonable certainty of procedure and likely outcome, then they might still find a way to buy bank bonds. But questions remain over which instruments will be covered by bail-in regulations, with some investors in senior debt clearly hopeful it will be limited to subordinated bonds and unwilling to accept their suddenly junior position in the capital structure below depositors.

It is still not entirely clear what types of capital instruments will be allowed to count towards capital ratios, although the assumption is that, even if they do not start as common equity tier 1, they must convert quickly into it. "The big question here is how to define the point of non-viability of a bank," says Morgan Stanley’s Krim. "The Canadian authorities have done a good job on defining this and disclosing their criteria. It would be extremely useful to get similar clarity in other jurisdictions."

Rather late in the day, regulators seem to be waking up to the notion of designing a framework for how the banking system should look rather than just piling one new rule on top of another. In January, Barnier appointed Erkki Liikanen, governor of the Bank of Finland, to chair a new panel of experts to consider whether, in addition to continuing regulatory reforms, structural reforms of EU banks would strengthen financial stability. That group is due to report back in the summer.

However regulators are no longer in charge of the process of consolidation and business model change now transforming banking, if they ever were. The providers of equity and debt to the banks, as well as the customers who provide their earnings, have a much bigger say.

Euromoney reported last month (see Investment banking: A whole new ball game, Euromoney, February 2012) on the consolidation in corporate and investment banking, particularly the FICC businesses, that is now gathering pace, despite regulators’ desire to reduce vulnerability to a small number of systemically important financial institutions. The initiatives they have set in motion are now helping to produce the opposite outcome.

"The question remains: what is the impact on the real economy of shrinking back an overly large European banking system to the smaller scale that the equity and funding markets are prepared to support? The market is imposing the discipline to reduce the banking system," says William Porter, managing director and head of credit strategy at Credit Suisse. "If policymakers take a view that that deleveraging is going too far to fast, an obvious response is to scale back on the regulatory burden. However, if regulators were to ease back on capital requirements now, investors would worry about the reasons for them doing that so much that the backlash might make it quite counter-productive." Porter believes large swathes of the European banking system can no longer function without ECB support and that the time is fast approaching for triage to discern between the survivors that can stand alone, those that can be treated and saved and those that should be read the last rites. "We are not on the right path with the banking system," he says.

"The answer is some kind of good-bank and bad-bank system in many parts of Europe, the transition to which is best not left to the market for fear of systemic bank runs. I don’t see how regulators in Europe can pretend much longer that this issue doesn’t exist. The LTRO may have prevented a vicious debt deflation for now but it is another attempt to cure a debt crisis with more debt and it is already subordinating other creditors to banks. That will be increasingly felt by holders of senior bonds of weaker banks."

He suggests: "This year is likely to see a renewed crisis that leads to some form of resolution of the European banking system." Could that require a substantial injection of state capital directly into the banks, perhaps roughly equivalent to the $700 billion under the US Tarp?

Against such an uncertain background, what, if anything, might cause policymakers urgently to rethink parts of the regulatory agenda?

Governments, remember, depend on banks not just to fund the real economy but also to fund governments themselves either directly by buying and holding their bonds or by underwriting and distributing them to investors.

Investors in European banks’ debt and equity have already shown what they think of banks stuffed full of doubtful government bonds. US investors abandoned European banks over the same concern, causing the banks to shed dollar assets funded in the wholesale markets.

"Putting a zero risk weighting on government debt was at the heart of the most recent phase of investor concern over stability of the banking system," says Skeet. "Now moving debt through the capital markets requires banks to be able to bid at auctions, sometimes warehouse government bonds and distribute them. But the whole FICC business has been severely impacted by the unintended consequences of increased regulation. Key trading and derivatives businesses are often described and characterised in public as ‘casino capitalism’, though in reality they represent liquidity and hedging operations vital to the smooth functioning of markets. If policymakers inadvertently undermine banks’ ability to undertake such business, they may well come to be regret it and learn in future to be more careful what they really wish for."

Christian Lajoie, head of prudential affairs at BNP Paribas, points out that one of the main difficulties banks have now in adjusting to the new regulatory framework stems from sovereign risk.

"It is difficult for banks to live with a highly volatile solvency ratio. You cannot manage it. You cannot raise capital quickly in response to sudden changes in the solvency ratio from one quarter to the next and so the approach of banks must be to mitigate this sovereign risk."

But that’s not easy. "If you try to hedge your sovereign exposure through credit default swaps, as well as taking basis risk, you also get hit with capital charges for credit valuation adjustments on your counterparty credit exposure which are likely to be very high because of the volatility of CDS spreads. So the easiest way to mitigate the sovereign exposure is to reduce it. The problem is of course, that when the Basle III rules were written, sovereign CDS volatility on this scale wasn’t anticipated. That’s a consequence of devising Basle III while we were still in the middle of a crisis."

Lajoie concludes rather glumly: "What is most troublesome for us is when regulation no longer makes sense against the economic and market backdrop. Ironically, I can see the US banks eventually implementing a smarter Basle III later than in Europe: not a version that’s necessarily more lenient but one that is better adapted to current market conditions."

In the US, regulators have problems of their own as shown by the astonishing lobbying process around implementation of the Volcker Rule. This is just one rule among thousands that have been promulgated under the Dodd-Frank act and it shows how dense and complex the banking industry is that adequately defining the difference between proprietary trading and market making to facilitate client business has proved so tricky.

US regulators surely cannot have expected the flood of letters they received as the comment period was due to close in mid-February running to many thousands of pages from hundred of interested participants, arguing that the Volcker Rule goes too far, that it doesn’t go far enough and every shade of opinion in between.

The banking industry pleads for better allowance for position-taking and warehousing of inventory in pursuit of facilitating customer business, suggesting that the rule risks reducing liquidity in important funding markets.

Many non-US commentators note that the rule exempts position taking in US government bonds and some take this exemption as an indicator that US regulators accept that the rule will inhibit liquidity and wish to preserve the treasury market as the bedrock of the US system on which all other traded financial markets depend.

The problem is that the extra-territorial reach of US lawmakers seems to threaten imposing restrictions on foreign banks with operations in the US that might reduce liquidity in other markets.

Mark Carney, governor of the Bank of Canada, writes: "The proposed rule appears to extend well beyond US-insured depository institutions and imposes significant restrictions on Canadian banking entities by limiting their use of US-based resources, personnel and market infrastructure and by preventing them from trading with US counterparties. "These restrictions may have important adverse consequences for Canada, limiting the liquidity of Canadian markets and hence the resilience of the Canadian financial system. Indeed, the proposed rule may undermine, rather than support, progress toward creating a safer, more resilient and more efficient global financial system."

Carney goes on to request similar exemptions from the rule on trading of Canadian government bonds that the US has carved out for US Treasury bonds, saying that a substantial portion of Canadian investor trading with non-Canadians in the country’s government bonds is conducted with US counterparties.

"It would be a particular concern if other jurisdictions enacted legislation with a similar home bias. The result would be a fragmentation of global capital markets, reducing their liquidity, financial stability and economic efficiency."

This plea comes from the same Mark Carney who heads the Financial Stability Board, the body brought together to coordinate the international regulatory effort. His letter to the SEC was posted in mid February just days after Carney’s senior deputy governor at the Bank of Canada, Tiff Macklem, also chairman of the FSB’s committee on standards implementation, delivered a rebuke to those lobbying for a pause in the regulatory onslaught to weigh the costs and benefits of actions already undertaken.

"Some are calling for a slowdown of the reform process, arguing that a weak global recovery and elevated uncertainty are good reasons to ease up on implementation.

"The global economy is certainly underperforming. The euro area appears to have fallen back into recession, with a sovereign debt crisis that poses clear and present downside risks. In the US, housing and labour markets have proven stubbornly slow to recover, and there is a large fiscal adjustment still to come.

"But the current challenges are not an excuse for delay. Quite the opposite – they underscore the urgent need to make the financial system more resilient. In a risky world, the need to make the financial system safer and restore confidence is vital. If there is a reproach to be made, it is that progress has not been faster."

So don’t lobby for delay or watering down of proposed new regulations – except when it touches too close to home for comfort.