The convergence of regulatory, government and economic forces on the financial sector is unprecedented. If much of the detail has yet to be determined and substantive differences between national authorities still exist, one thing that is certain is that the financial services industry will look very different in a few years' time.

The number of new rules confronting banks will bring about seismic change in the financial services industry. From new capital and liquidity requirements, to resolution and recovery planning, to tighter constraints on business lines and leverage, to changes in market infrastructure and improvements to consumer protection, banks face a regulatory tidal wave.

And they must act while the current is still moving. While the direction already set for the industry was upheld by last year's G20 summit in Cannes, at a national and regional level, a huge amount has yet to be finalised and implemented.

Neither is it always a smooth process. “Beneath the top level global agreement, we are seeing a growing level of dissonance about making it happen,” says John Liver, head of global regulatory reform, Europe, the Middle East, India and Africa, at Ernst & Young.

Aside from the practical difficulties in implementation, different approaches to the fundamental building blocks for global reforms are proving problematic. For example, there are differences in terms of insolvency regimes, on what businesses banks are allowed to do, as well as whether or not to impose taxes on financial transactions. The potential for arbitrage by the industry and potentially damaging unilateral changes by national regulators is great.

Divergent approaches

Around insolvency regimes, for example, authorities are not only nervous about what they are on the hook for in their own country, but concerned about their ability to control or influence what happens in the other countries in which their banking groups operate and where insolvency regimes differ, so tensions and concerns have emerged. As a result there have been individual moves towards subsidiarisation, which would mean trapped capital and trapped liquidity at a time when both are scarce. Many see this as detrimental to economic growth.  

The cumulative effect of all this for the industry is three-fold: there is a short-term existential threat around having enough funding to remain operational; in Europe, there is a six-month threat around getting up to the revised level of capital demanded by the European Banking Authority; and longer term, there is a compliance and business model threat around adapting businesses to the new environment.

“At the moment, there aren't many answers to any of the three,” says Mr Liver. “Funding isn't easy to find and what to put in the liquidity buffer is still a moot point; the environment for raising capital is inhospitable to say the least; and redefining the business model to ensure both compliance and profitability is a complex, strategic optimisation exercise that will prove incredibly challenging.”

The great deleveraging

What banks can do to reduce funding needs, and meet capital and liquidity requirements, is shrink. And they are doing it at quite a pace. Businesses that consume lots of capital but are relatively low in profits are being shrunk aggressively. Trade finance has seen traditional players pull back in a bid to boost capital, and lenders such as Royal Bank of Scotland, France's BNP Paribas and Société Générale, and German landesbanken currently have books of aircraft, shipping and infrastructure finance up for sale. 

According to a research note from Nomura, eurozone banks hold more than $6000bn in cross-border (non-eurozone) assets, and many of these are likely to be for sale. The note says that even while European banks did not really releverage after the financial crisis, since March 2009, external assets have shrunk at an average pace of €5bn a month. This compares to an average monthly external asset growth of about €60bn from mid-2005 to the end of 2007.

Deleveraging is not just a European problem. In the US, Bank of America-Merrill Lynch alone has reduced its risk-weighted assets by $117bn since the third quarter of 2010 in a bid to increase its capital ratios, and other banks, including Morgan Stanley, have stated that they are reassessing what business lines they should still be doing.

Moreover, there is significant risk that a retrenchment by European (and other) banks will have a big effect on other regions – most worryingly on their eastern European borders, where banking is highly reliant on western European banking groups – but also in Asia. Data from the Bank for International Settlements show that continental European banks are responsible for 21% of the $2500bn in loans outstanding, excluding Japan. Neither will Latin America escape unscathed, as Spanish banks such as Santander pull back and sell down assets in order to augment capital ratios.

Whilst some of the assets that are up for sale are being actively bid for by other banks, most notably Japanese and Chinese players, and new players may enter to fill the gap left by exiting banks, some areas of business, such as credit provision for small to medium-sized enterprises, will be hard hit.

Going forward this suggests a very different industry in a few years' time, with consolidation of banks in developing countries, only a few surviving global institutions, a simplification of bank portfolios, and regulatory arbitrage as banks favour jurisdictions most friendly to talent and capital.

Shadow banking

More importantly, a shrinking bank model has huge implications – and one which should worry regulators. As banks deleverage and withdraw, many of their activities are moving to the non-bank or so-called shadow banking sector. 

A recent report from the Financial Stability Board (FSB) reveals that the assets of non-bank credit intermediaries in Australia, Canada, Japan, South Korea, the UK, the US and the eurozone had risen to $60,000bn by the end of 2010, surpassing the $56,000bn reached before the financial crisis in 2008.

The FSB estimates that such shadow banking constitutes an astonishing 25% to 30% of the total financial system and, with regulation on banks still tightening, most expect that this figure will continue to rise. This should concern regulators, says Patricia Jackson, head of prudential regulation and risk at Ernst & Young.

Regulators may need to reconsider and fine-tune the leverage definitions of banks to incorporate collateral chains due to the sizeable volumes of pledged collateral that churn between banks and non-banks

IMF paper

“Shadow banking runs the same kinds of risks, including credit risk transfer and leverage, maturity transformation and liquidity transformation, yet by its nature it is much more opaque and therefore it is hard for regulators to identify and monitor these risks,” says Ms Jackson. “Crucially, much of this activity falls outside the regulatory perimeter but involves credit intermediation chains in which conventional banks are involved. This makes shadow banking a significant factor in overall systemic risk.”

Collateral connection

Against a backdrop of regulatory efforts – from Basel's liquidity ratios and moving over-the-counter derivatives to central clearing – that are pushing for more collateral, the interplay between banks and shadow banking gets ever more complicated.

In a recent International Monetary Fund working paper, 'The non-bank nexus and the shadow banking system', authors Zoltan Pozsar and Manmohan Singh describe how asset managers – including hedge funds, exchange-traded funds, pension funds and insurance firms – have become the key financiers of the banking system and the “ultimate sources of collateral” for the shadow banking system.

Will recovery and resolution  planning push banks that operate internationally towards more local business models?

Via the process of rehypothecation, long, complicated collateral chains are being created and something the authors call “reverse maturity transformation” is taking place. In this, asset managers (especially real money managers) who traditionally make long-term investments, voluntarily transform their long-term assets into short-term liabilities, largely as a way to boost returns.

As a corollary, since asset managers typically want to reinvest the cash collateral received for such securities lending, there has been an increase in cash reinvested into extremely short duration paper that is as high yielding and as 'safe' as possible, such as treasury bills and repos.

The volumes involved are significant. According to the paper, at the end of 2010 there was something like €5800bn in off-balance sheet items of banks related to these sort of 'collateral mining' operations and collateral re-use. And, since it is difficult to track the linkages of this sort of reverse transformation and re-use of collateral, the authors suggest that the process can have serious implications for an understanding of financial institutions' balance sheets and the measurement of financial and monetary aggregates.

The increased risk of a collateral crunch would lead to much greater funding stresses than might otherwise have been expected – and this has real micro- and macro-prudential implications, say the authors.

“Regulators may need to reconsider and fine-tune the leverage definitions of banks to incorporate collateral chains due to the sizeable volumes of pledged collateral that churn between banks and non-banks,” says the paper. “For example, Lehman, at the eve of its bankruptcy, had $800bn in pledged collateral that could be repledged in Lehman's name, while its balance sheet size was only about $700bn.”

Economic impact

The convergence of regulatory, government and economic forces on the financial sector is unprecedented, and many argue that policy-makers' belief that the slew of changes will have a negligible effect on the global economy is overly optimistic.

Holding more capital and lower-yielding liquid assets will depress bank returns. Estimates vary, but many argue that returns on equity in investment banking could fall from about 20% in 2010 to about 7%. As a result, firms will charge more to clients and close down capital-intensive businesses; but even with such actions, returns could dip to 12% to 14% and barely cover banks' cost of capital.

While this may lay bare that much bank activity was made profitable by levering up, it will have implications for the global economy as banks constrain the supply of credit or raise prices to bolster returns. According to the Institute of International Finance, the combined impact of new banking regulations may be to cut gross domestic product by 0.7% a year over the next five years and could cost some 7.5 million jobs in the process.

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