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Forthcoming challenges to banking regulation (sovereign risk, RWA variability, trading book…) - Resilience of the EU financial sector in the global context

Time to recognize the impacts of the post-crisis regulatory overhaul

By Bini Smaghi Lorenzo - Chairman, Société Générale

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The clamp down on banking activities in the wake of the financial crisis was a necessary response to an immediate threat. Time is ripe to recognize the impacts of the post-crisis regulatory overhaul on the funding capacity of European banks as demonstrated by the parallel initiatives of the European Commission (call for evidence) and Parliament (own initiative report).

With Basel III still to be fully implemented and further measures to come, improperly referred to as “Basel IV”, the adjustment of the euro area financing channels is still in motion with (i) continued constraints on liquidity providing activities, and (ii) threats on bank lending capacities in the event of better growth perspectives.

De facto, liquidity providing activities are challenged by the various regulatory reforms, which to name a few include:
– CRD4/CRR (i) the requirement to raise the quality and level of capital to cover RWAs, (ii) the capital charge for variations in counterparty risk and (iii) the leverage ratio, that encourages banks to withdraw from activities that are low-risk but generate little income and now consume too much capital,
– Review of the Trading Book (FRTB) is set to increase capital requirements,
– LCR forces banks to tie up large amounts of instruments on their balance sheet, diverting resources away from liquidity providing activities, while NSFR is expected to penalize repo and derivatives activities.

Several other texts could further impact liquidity providing activities such as financial tax rules (FTT) or structural reform of banks (BSR).

Remarkably, the latest update of the IMF’s Global Financial Stability Report underlined the systemic nature of liquidity risk on financial markets, estimating that the costs to investors of a liquidity crisis could exceed EUR 100 billion

Time is ripe to recognize the impacts of the post-crisis regulatory overhaul.

In Europe where banks withhold a greater share of risks in their balance sheets the new prudential environment has led to significant adjustments to their liabilities (capital increases, earnings retention, lengthening of debt maturity, increase of deposit rates…) and assets (reduction of long-term loans or activities that do not provide deposits, reducing the risk on the balance sheet by using the model “origination and distribution” and securitization…).
To avoid penalizing the long-term financing of the economy and of SME’s requires several adjustments in the non-banking sector too:
– need to increase savings invested on a long term horizon so that the reduction in bank lending does not translate into a decrease in productive long-term investment;
– need to improve direct access to investors (in substitution of bank loans) for borrowers who do not (or with difficulty) have the ability to issue directly in the markets.

These changes will necessarily take time and could lead in the meantime to financing difficulties for some corporations.

The imbalance between liquidity supply and demand creates a worrying weakness especially with monetary policy normalization ahead, however for the coming years, these difficulties should remain limited because of the expected slow macroeconomic environment in the euro area where the demand for financing itself is likely to remain constrained by prolonged sluggish growth.