Proposed financial regulation is dangerously pro-cyclical and risks creating another bubble in the shadow banking system, while creating extra incentives for banks to take on more risks. Or so the critics – wedded to the idea of marrying voluntary industry self-regulation with supervision – frequently argue. However, financial laissez-faire is dead. Conscious of swimming in vain against the regulatory tide, bodies, such as the Institute of International Finance (IIF) now aim to water down some of the Basel proposals, while broadly welcoming the Basel’s new capital regime.
They add that market pressures to accelerate the adoption of Basel III capital rules, a flurry of different banking reform timetables and capital definitions have served to undermine credit transmission.
However, bankers, lobbyists and regulatory officials that Euromoney has spoken with also fear that the regulatory debate has focused too much on advanced economies, with scant attention to the interests of emerging economies.
Here are some specific concerns:
- In March 2011, BBVA Research released an impact study of financial regulation on emerging countries and came to a dispiriting conclusion: tighter financial regulation, which has been designed and implemented to curtail excesses in Europe and the US, could have a disproportionately larger impact in headline GDP terms for emerging economies.
The results show that if capital over assets increases by 20%, the impact in GDP per capita terms would be -1.6% for a broad set of countries and -2.5% for emerging countries, specifically. In turn, if liquid reserves over assets increase by 20%, the effect from a GDP per capita perspective equates to -0.4% for the whole sample and -0.5% for emerging economies.
The scarcity of capital combined with the need for banks to hold more capital and liquidity relative to a given pool of assets – due to the higher credit risk in emerging markets – account for this underperformance.
- Beggar-thy-neighbour financial regulation, coupled with the eurozone banking crisis, could also negatively impact emerging economies, argues Charles Dallara, head of the IIF. He tells Euromoney: “The central banking and regulatory community, in general, have done a mediocre job in owning up to their mistakes in contributing to the crisis and, subsaequently, the troubles post-crisis. They owe to their constituents to articulate a view that prosperity and stability won’t arise if we take a nationalistic, fragmented and beggar-thy-neighbour view of financial regulation.”
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| Charles Dallara, IIF chief |
Of particular concern is the fact banks need to ensure that international subsidiaries are self-funded to convince regulators and shareholders they have a sustainable funding model. In addition, capital is no longer considered fungible across borders, even within Europe – an issue exacerbated by the UK Financial Services Authority’s move this May to ring-fence liquidity from Santander UK from the parent. Bankers harbour fears that local branches of foreign banks will be forced to hold costly regulatory capital, given concerns over the convertibility of certain capital instruments under Basel III. For example, these branches might find difficulties in issuing convertible debt in the host jurisdiction if there is no market for their equity – since the parent bank generally owns 100% of that equity, unlike Santander and HSBC’s subsidiarity business model.
As a result, buyers of these convertible instruments might require a premium to offset the illiquidity, thereby increasing the overall cost of capital, bankers say.
These challenges are not specific to emerging markets, and the treatment of contingent convertibles as regulatory capital differs between national supervisors, but as global banks focus on core markets, these extra capital costs will surely bite.
- Bankers fear rising costs in trade and infrastructure finance, two key forms of emerging-market finance. The Basel Committee’s decision to enforce a non risk-weighted leverage ratio for trade finance transactions – despite the instruments boasting low default rates – could substantially increase the cost of a number of trade financing products and negatively impact global commerce, according to industry analysts.
What’s more, aside from global banks’ capital constraints and the higher cost of bank capital, more generally, more onerous liquidity requirements, as proposed – such as net stable funding ratio – would require banks to aggressively match-fund assets. This would undermine the role of banks as maturity transformers, further increasing the cost of long-term infrastructure financing and intensifying the dependence of emerging economies on local bank lenders for vanilla loans.
In addition, “cross-currency swaps for foreign bond issues or multi-currency syndicated loan facilities are now more expensive thanks to new credit valuation adjustment capital charges and higher initial margin requirements,” says the IIF’s Nixon. “Put simply, bringing money from one part of the world to another is now more expensive.”
- Questions are also being raised about the unintended consequences of new financial regulation on US investment banks in emerging markets. Take the US’s Volcker rule, which, as proposed, allows deposit-guaranteed US investment banks to hedge against risk, but does not allow principal trading for profit.
This could also have a particularly negative impact in emerging markets, says Wayne Abernathy, executive vice-president for financial institutions policy and regulatory affairs at the American Bankers Association.
“Market making is supposed to be exempt from the rule, but some banks might need to take proprietary positions to set bid-ask spreads in a relatively illiquid emerging market to support their market-making capabilities, and distinguishing between the two activities will be difficult,” says the Washington-based lobbyist, though bankers are more sanguine about the impact of this regulatory burden for emerging markets.
It is still too early to determine the full consequences of regulation on the economics of banking and credit growth, especially since many of the more-bearish studies have been conducted by self-interested parties. What’s more, many pillars of regulation, such as the Volcker rule and Basel III’s liquidity regime, are still up for negotiation. However, the impact of regulation on the economics of global banking is clearer: capital costs are rising, challenging the cross-border banking model at a time of weak global economic and capital-market activity.