On that side is a world of safe banks lending to the real economy and partially funded by knowledgeable investors taking a modest risk. Those same investors will also be buying securities to provide an alternative source of funds to the economy – secure in the knowledge that Capital Markets Union will provide a safe market structure for their investments. The snag is that there is still quite some uncertainty about the exact location of the cliffs at the edges of the chasm.
Taxpayers have revolted at the idea of bailing out large banks and have insisted that no bank be “too big to fail” (TBTF) so legislators have responded by enacting a complex and sophisticated set of laws to ensure that losses fall on shareholders and then on some classes of bond-holder, while ensuring that small depositors/voters are left secure. The G20 Head of Government have demanded that the global playing field be level and set up the Financial Stability Board (FSB) to orchestrate the process.
The EU responded by enacting a battery of laws to eliminate the risk of TBTF by making it possible to “resolve” banks yet maintain their key functions within the economic system. These measures include: Capital Requirements Directive (CRD), Capital Requirements Regulation (CRR), Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRMR). Some of these include secondary legislation from the European Commission and a vast array of Implementing Technical Standards (ITS) and Regulatory Technical Standards (RTS).
However, second thoughts are now setting in about whether this regulatory tsunami may have gone too far and, in November 2016, the Commission published a package of proposals that included a softening of the resolution measures in some key respects. This is not surprising as a recent Commission staff paper laid bare some of the problems stemming from all these measure interacting with each other.
The paper – Bank Lending Constraints in the Euro Area - assessed the lending constraints faced by the euro area banking sectors due to a combination of low profitability, weak bank equity markets and the phase in of new capital requirements. Banks have already anticipated many of the additional capital requirements in the next few years but the authors point out that “new measures such as the leverage ratio, the fundamental review of the trading book, the reform to reduce variability in risk weights and IFRS9 are expected to be enshrined in legislation and implemented over the next few years. These measures are likely to have a non-negligible impact on capital requirements and banks are probably less prepared for them”.
The authors look at two scenarios of increased CET1 ratios – with the upper one based on a 1.5 percentage point increase. Their model suggests that the stock of loans would be reduced by 10% over the three years while this increase is feeding in – leading to a cumulative GDP contraction of 1.5%. The severity of the model’s outcome – with all the caveats about economic models – reflects the Catch-22 situation for Europe’s banks. The median return on equity is about 8% - probably below the cost of that equity - and the average ROE (from the EBA’s 131 bank sample) is only 5.7%. With bank equity selling at around half book value, bank shareholders are hardly about to rush to issue more equity so the logical way to raise capital ratios is indeed to shrink the balance sheet – with all the economic consequences that implies.
But this is the moment where the step across the unknown chasm suddenly looks particularly un-appealing: “Pillar 1” capital must reach 16% of Risk Weighted Assets (RWA) by 2019 and 18% by 2022. Pillar 1 capital includes Core Equity Tier 1 (CET1) – pure equity – which stood at 13.2 % on average for EU banks in June 2016. The rules permit 1.5% of Additional Tier 1 capital – bonds that can be converted to equity in extremis and 2% of Tier 2 capital – subordinated bonds. At present, the EBA sample has an average Pillar 1 ratio below this target.
In the absence of a sudden surge in profits, that shortfall will have to be made up by a dramatic increase in the issuance of AT1 instruments and Tier2 bonds. However, the bond market must simultaneously cope with the progressive conversion of standard bank senior bonds into subordinated instruments that are now to be part of the Minimum Requirement for Eligible Liabilities (MREL). This means that such bonds can be `bailed in’ by the regulators, causing the holders major losses. So bondholders are likely to want to know their risk of suddenly being bailed in and that is where the cliff edge remains distinctly unclear.
This is the Doomsday Machine of resolution capital: If Europe’s banks cannot roll over their standard bonds into “MREL” bonds, then balance sheets must contract – with all the well-specified economic ills that will follow.
© Graham Bishop
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