EC propose recapitalisation plans
Significant banks may be forced to temporarily raise additional capital with restrictions on dividends and bonus payments on an interim basis, according to proposals released by the President of the European Commission (EC), José Manuel Barroso. As part of its road map to stability and growth, the EC called for ‘significantly’ higher capital reserves to help banks replenish their balance sheets to withstand market turmoil amid the eurozone’s sovereign debt crisis.
The coordinated bank recapitalisation strategy would cover all potentially systemic banks in the EU, equating to around 90 firms. According to the proposals, all sovereign debt exposures should be taken into account to ensure full transparency on asset quality.
For Greek sovereign debt, President Barroso suggested that some form of private sector haircut was required, although he gave no indication of the appropriate level. The proposals put forward by the Commission represent a much bigger recapitalisation of European banks than was envisaged by last summer’s stress tests, as some form of sovereign debt write-down, starting with Greece, is anticipated.
While falling short on specifics, various sources have indicated a 9% core tier 1 (CT1) capital ratio to risk-weighted assets will be adopted by the European Banking Authority (EBA) when it assesses exposure to sovereign debt, if the road map is adopted at the EU summit later this month. Such a requirement would put considerable strain on banks and could place them at a competitive disadvantage against their international peers given that the Basel III ratio of CT1 is only 6%. It would also be a considerable shift in the EC’s previous position which suggested setting Basel III capital requirements as the maximum standards across the EU, in line with initial Franco-German proposals. The rumoured CT1 level is also considerably higher than the 5% set by the EBA during its stress test exercise in July.
While the Basel III capital requirements will not fully apply until 2015 to allow banks to comply with requirements gradually, the Financial Times reported on Wednesday, that European banks will be given only 6 to 8 months to bring their capital reserves in line with the new requirements. In practical terms, national supervisors should establish these requirements using their existing supervisory powers in the form of additional buffers which prevent the distribution of dividends or bonuses pending the recapitalisation, according the EC’s proposals.
To raise additional capital to buffer against sovereign debt write-downs, banks may be forced to jettison non-core business operations and scale-back or deleverage elsewhere. Such restructuring scenarios are already been being discussed at BNP Paribas and Société Générale, according to press reports. This strategy may be adopted by other European banks as they face a number of challenges in raising capital through private sources.
Firstly, management may hesitate to raise capital through a rights issue given the depressed nature of their stock— the average European bank’s equity is trading at only about 60% of its book value. The debt market is volatile and we have seen some large players unwilling to roll-over dollar denominated debt to European banks in recent months. While investors will return to this market as they search for higher yields when market conditions stabilise, European banks, as it currently stands, already have significant short-term funding refinancing needs. Morgan Stanley estimates that around 1.7 trillion euros of senior debt of more than a year’s maturity will have to be rolled-over by European banks over the course of the next three years, which could leave little room to raise additional capital.
While banks’ retrenchment strategy may be the only viable option for meeting the new requirements through private means, there is a concern that this will reduce lending in the real economy and dampen any meaningful economic recovery. The situation highlights the complexity of the interdependence between banks and public revenues. A strong banking system helps stimulate private investment in the economy which in turn generates taxable revenues. European firms rely on banks for as much as 80% of their funding compared with only 30% for U.S. firms. Similarly, if governments restore the long-term sustainability of their public finances, the risk premium on banks’ exposures to sovereign debt will be reduced, bringing down the need for additional capital at banks.
It is very likely that national governments will step-in and provides some form of temporary support if their systemic banks are unable to raise capital at sustainable rates. The French government, for its part, stands ready to inject capital into its beleaguered banks, if necessary. If national support is not available, though, recapitalisation may be funded by a loan from the eurozone bail-in mechanism — the European Financial Stability Facility. However, President Barroso outlines that public interventions must strictly follow state-aid rules for bank support to ensure the level playing field in the single market. A recent EC staff working paper on state-aid concluded that the temporary framework for state-aid during the financial crisis worked properly, and plans to extend it to the end of 2011 were justified. However, when the crisis is finally over, the provision of state-aid should return to the objective of less and better targeted aid. The working paper, notably, did not discuss how future state aid practices will be work with and complement the anticipated regulatory framework for recovery and resolution planning.
In effect, a stressed situation envisaged in the recovery and resolution scenarios is already upon us. Similarly, if state-aid is given, nationalised or quasi-nationalised banks will be required to significantly restructure their operations and hive off any profitable business units to repay public support. Some investment banks already predict that the disposal of fund management and private equity arms of European institutions this year may buoy the weak mergers and acquisition markets. Irish banks are considerably further along this process than their peers elsewhere in Europe. In 2010, Bank of Ireland was forced to sell its asset management and life assurance businesses and a building society to comply with state-aid rules. Similarly, Allied Irish Banks had to sell profitable international arms in Poland and the U.S. before passing EU state-aid rules.
However, it is clear that bank weaknesses will not be addressed through restructuring alone. Previous efforts to address the sovereign debt crises were labelled ‘reactive’ and ‘piecemeal’ by the EC President José Manuel Barroso, indicating that more decisive and coordinated action is now needed to end the ‘vicious circle’ of concerns over the sustainability of sovereign debt, the fragility of the European banking system and overall economic growth prospects. Therefore the road map also calls for immediate action in addressing Greece’s fiscal problems; enhancing current backstops, frontloading stimulus policies, and adopting more integrated economic governance.
Against a backdrop of the indecision and division between Member States on how to solve the sovereign debt crisis, the road map is timely and might help frame negotiations when heads of State meet at the forthcoming EU summit on 23 October. It also places the EC at the heart of discussions around crisis management in Europe which recently have been increasingly framed by bilateral meetings between the French and German governments. The EC is keen to show that it has an important role to play in coordinating actions across the Union. Delivering agreement on its road map would be a major win for the EC and the entire European project.
G20 – Handicapping the Cannes Leaders’ Summit
During the financial crisis of 2008, the G20 took the lead in driving co-ordinated action in order to strengthen regulation and supervision of the global financial system.
This year’s G20 Leaders’ Summit in Cannes on 3 and 4 November comes once again at a critical juncture. The G20 has to prove that it can adapt to the new challenges of the current economic environment. According to its own publicity, “It must prove that it is able to coordinate the economic policies of major economies on an ongoing basis ... today's key economic challenges require a collective and ambitious action”
The current challenges obviously include the crisis over sovereign debt in Europe and extreme market volatility. However, the Financial Stability Board (FSB) in recent weeks has highlighted other systemic risks that continue to need close attention: for example, addressing systemically important financial institutions, dealing with the threat of shadow banking, with the rapid expansion and increasing complexity of Exchange Traded Fund’s (ETFs);the upsurge in algorithmic trading, particularly high frequency trading; with short selling and the impact of uncovered credit default swaps on financial stability. G20 nations are coming to Cannes with different agendas. The US has just tabled its proposals for the assessment of ‘systemic importance’ and is pushing ahead with its approach to OTC derivatives. The European Union plans to table discussions on a financial transaction tax which, in the context of the current crisis, may prove an unfortunate red herring.
Monitoring work undertaken by the FSB has shown that the extensive G20 agenda is characterised by different implementation speeds, differing priorities, and the propensity to build in ‘flexibility’ for national and regional specificities. In the face of global challenges, the national pressures for divergent solutions are large. Can the G20 keep its focus to make progress on its core regulatory priorities, and in so doing, create a more level "playing field" to minimise the opportunities for regulatory arbitrage? Comparative advantages can be exploited by nimble financial institutions, often at the expense of other participants, quickly making existing business models uncompetitive and non-viable.
Commentators last year worried that the initial momentum of the G20's Pittsburgh/Washington/London summits was dissipating and being watered down by agreements (e.g. on capital requirements for systemic institutions, Basel III) which were only achieved by providing “flexibility” for nations to supplement the basic agreement (with additional capital buffers). The agreements achieved at the upcoming Cannes Summit may reveal a great deal about the future capacity of the G20 to achieve a level playing field in key areas. Institutions should be careful to read the signals, and their business implications.
Some areas to watch:
- OTC derivatives - Look for signals about commitment to shared principles for derivatives trading rules, including commodities. It is worth noting that the FSB, in its 3 October press release, stressed that “the reforms to OTC products committed to by the G20 and set out in more detail in the FSB October 2010 report, are to be fully implemented irrespective of whether those products continue to trade OTC or are moved onto organised platforms”. A priority for US negotiators, the FSB’s comment raised questions about the comprehensiveness and timing of EU approach.
- LEI’s (Legal Entity Identifiers) - This seems to be emerging as an important step in the process of understanding counterparties, risk concentrations, and also enabling international resolution. To date, it seems relatively uncontroversial. Look for an agreement to which commits to developing a single global system for LEI's.>
- Financial Transactions Tax– As indicated above, this is an EU priority but it does not have unanimous support even within the EU. Most notably, the UK is worried that its implementation in Europe could see huge shift in trading activity away from especially London to other financial centres. However, although the proposal has been tabled in the EU, it is not a ‘done deal’ so negotiations will not be on a completely sound footing. Canada and the US are clearly opposed to such a tax. However, an agreement which even provides "flexibility" for national implementations, would signal real determination on the part of the EU to progress this.
On OTC Derivatives, the FSB published a report on 11 October detailing current progress on the implementation of market reforms. The FSB is concerned that many of its members will fail to meet next year’s deadline to overhaul their OTC derivatives markets to make it less risky and more transparent. Few countries have either legislation or regulations in place that will “provide a framework for operationalising the commitments” made at previous summits and the Basel-based body has called on countries to “aggressively push forward” on OTC reform in the coming months. The U.S. is ahead of most jurisdictions in terms of implementing new rules. However, European policy makers have picked-up speed recently: the current trilogue negotiations between the European Parliament, the Council and the EC are expected to proceed smoothly and relatively quickly with the result that the regime for OTC derivatives will be in place by the December 2012 deadline. However, rules relating to derivatives generally will only be dealt with in the amendments to the Markets in Financial Instruments Directive (MiFID) which will only be tabled this month. Other G20 countries appear to be waiting to see how the final rules in the US (Dodd-Frank) and Europe (EMIR, MiFID II) will shape up, particularly give the often frank exchanges between both camps on the robustness of their reformations. Similar to other regulatory areas, the FSB believes that other countries need to advance development of their own legislative frameworks and not just wait for the US and EU regimes to be finalised.
Assessing the cumulative impact of European regulations
The Economic and Monetary Affairs Committee (ECON) of the European Parliament published a study recently assessing the likely impact on how the most important regulatory changes in Europe will contribute to various objectives (such as transparency and increasing consumer confidence), together with a joint impact assessment on all the regulation coming down the pipeline. Both assessments are informed from relevant research and some new empirical work.
The outputs are qualitative in nature, the key finding under each regulation can be summarised as follows:
- Revisions to the Capital Requirement Directive (CRD IV). Overall, the ECON report concludes that benefits that accrue from higher capital requirements— namely by reducing the probability and severity of financial crises—will far exceed its costs, in terms of higher financing costs for banks and a reduction in lending in the economy. While the new capital requirements will not necessarily reduce the likelihood of bank failures, it will diminish the severity of financial crises when they occur.
- Regulation of Over the Counter (OTC) Derivatives: The impact of this regulation on the market and real economy are generally seen as positive. Enhanced transparency will help regulators access risk better and prevent liquidity crunches. Central counterparty clearing facilities will reduce credit risk exposures and the default probability of individual members.
- Short selling and credit default swaps (CDS): The report outlined some positive (reducing market abuse) and negative (deteriorating market liquidity) impacts associated with temporary bans on short-selling and CDS trading.
- Credit Rating Agencies (CRA): The impact of regulation in this area is difficult to quantify. Making CRAs more liable for their ratings may improve the robustness of their ratings, although, how this can be done in practice is difficult to see. Increased competition in the CRA industry could bring down costs for banks but it could also increase the risks of financial institutions ‘shopping’ for the most beneficial rating (and not necessarily the most accurate).
- Reform of Deposit Guarantee Schemes (DGS): Costs incurred by pre-funded DGS will vary for banks. However, the practice of internalising at least some of the costs associated with banking failures is good for market discipline. The report highlighted the concerns that banks could circumvent DGS and transfer risks through shadow banking.
- Reform of Investor Compensation Schemes (ICS): The overall impact of changes for investors will be moderate, according to the report. Harmonisation of ICS across Europe will increase investor confidence.
- MiFID: The report does not examine the impact of MiFID II proposals (final proposals should be released this month). Instead, it finds that the Directive in its current state has increased overall market liquidity and cut costs for investors. Problems related to the fragmentation of trading venues, dark pools and a lack of transparency in MiFID where highlighted in the report.
- Financial Transaction Tax (FTT): The costs associated with a FTT will be passed on to customer of financial institutions directly, according to the report. Research is unclear as to whether a FTT will enhance market stability in any way.
- Additional capital requirements for systemically important banks: Additional capital will reduce the probability and scale of financial crisis without any major consequences on bank lending. The costs to industry of extra capital requirements will be very small. As a consequence, the report suggests that current proposals for a surcharge on important banks by an additional 1-3.5% of equity “seems well-founded from an economic point of view”.
- Bank restructuring and resolution procedures: These measures are generally positive for most stakeholders in the long-run, internalising the social costs of bank failures, increasing incentives for better governance and monitoring of banks by their shareholders and debt holders.
In terms of the joint impact assessment, while it is non-scientific, it does provide an interesting take on how even policy makers are unsure on how different regulations will interact with each other following their implementation. Overall, the study notes that the regulations above are likely to reduce procyclicality, internalise the social costs associated with bank failures and create a level playing field across the single market. However, the report concludes that, apart from the DGS and ICS, none of the regulations will increase consumer confidence in financial markets in a meaningful way.
Regulatory regimes are now in flux. How the most important rule changes will impact financial institutions, markets, customers and the real economy is a pressing issue for many stakeholders. Understanding the cumulative impact of regulations, and how they interact with each other, is even more relevant as financial institutions face a plethora of regulatory changes in the coming years. Financial planning and business model restructuring needs to take account of all the regulatory (and accounting and legal) changes that face their operations. Having the correct structures in place to navigate regulatory change will not only result in cost efficiencies but it can also put financial institutions in a better position to capitalise on the opportunities that the regulatory changes will trigger.
FSB consults on a common data template for systemically important institutions
The Financial Stability Board (FSB) has developed interim proposals for a new common data template to be completed by G-SIBs, with the objective of ‘strengthen(ing) information on financial linkages between major banks and on their exposures and funding dependencies’. Other large significant banks may also be asked to complete the template in order to improve understanding of the linkages within the global financial system. The FSB and national authorities are considering storing and pooling on a harmonised basis in a central hub the template data collected nationally which will be hosted by Bank for International Settlements (BIS).
The consultation closes on 8 November 2011 for which the FSB will present its finding to the G20 summit in Cannes. The FSB also intends to use the feedback to deepen its cost-benefit analysis and narrow the range of options in developing a final data template. The working group will then carry out further piloting and consultation on the FSB's detailed proposals. The template will be introduced in stages to give G-SIBs time to meet the new requirements.