Post crisis banking regulation in the european union

Post-Crisis Banking Regulation in the European Union Opportunities and Threats Katarzyna Sum Post-Crisis Banking Regulation in the European Union Katarzyna Sum Post-Crisis Banking Regulation in the European Union Opportunities and Threats Katarzyna Sum Warsaw School of Economics Poland ISBN 978-3-319-41377-8 ISBN 978-3-319-41378-5 DOI 10.1007/978-3-319-41378-5 (eBook) Library of Congress Control Number: 2016953881 © The Editor(s) (if applicable) and The Author(s) 2016 This work is subject to copyright All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made Cover illustration: © Mark Sykes / Alamy Stock Photo Printed on acid-free paper This Palgrave Macmillan imprint is published by Springer Nature The registered company is Springer International Publishing AG Switzerland Contents Theoretical Aspects of Banking Regulation Basel III: Assessment of the Guidelines for  Regulatory Reform 41 Post-Crisis EU Banking Regulation: Assessment and Challenges to Implementation 75 Bank Governance in the EU: A Substitute or Complement of Banking Regulation? 133 The Factors Influencing the EU Banking Regulatory Framework: Impediments for the New Regulations 169 Banking Regulation and Bank Lending in the EU 209 Summary and Conclusions 251 Index 257 v List of Abbreviations AIFM AIFMID BCBS BRRD CDS CoCos CRD CRM CRO CRR CVaR DGS DGSD EBA EC ECB ECOFIN EDIS EFP EFSF EFSM EIB EMIR ESA Alternative Investment Fund Managers Alternative Investment Fund Managers Directive Basel Committee of Banking Supervision Bank Recovery and Resolution Directive Credit Default Swap Contingent Convertible Bonds Capital Requirements Directive Comprehensive Risk Measure Chief Risk Officer Capital Requirements Regulation Conditional Value at Risk Deposit Guarantee Schemes Deposit Guarantee Schemes Directive European Banking Authority European Commission European Central Bank Economic and Financial Affairs Council European Deposit Insurance Scheme Employee Financial Participation European Financial Stability Facility European Financial Stabilisation Mechanism European Investment Bank European Market Infrastructure Regulation European Supervisory Authorities vii viii ESM ESMA ESRB EU FCD FSB GDP IASB IMF IRC LCR LOLR MIFID NPL NSFR OTC PIT ROA ROE SSM SRM SVaR TTC TVaR UCITS VaR VIF List of Abbreviations European Stability Mechanism European Securities and Markets Authority European Systemic Risk Board European Union Financial Conglomerates Directive Financial Stability Board Gross Domestic Product International Accounting Standards Board International Monetary Fund Incremental Risk Charge Liquidity Coverage Ratio Lender of Last Resort Markets in Financial Instruments Directive Non-Performing Loans Net Stable Funding Ratio Over The Counter Point-in-Time Ratings Return on Assets Return on Equity Single Supervisory Mechanism Single Resolution Mechanism Stressed Value at Risk Through-the-Cycle Ratings Tail Value at Risk Undertakings for Collective Investment in Transferable Securities Value at Risk Variance Inflation Factor List of Figures Fig 2.1 Fig 3.1 Fig 3.2 Fig 3.3 Fig 3.4 Fig 3.5 The pillars of Basel III Sovereign yields of peripheral countries (%) Total recapitalisation and asset relief state aid used by EU member states between 2008 and 2014 (% GDP.) The growth rate of foreign branches’ assets from other EU countries The growth rate of foreign subsidiaries’ assets from other EU countries Tier capital to assets ratios of EU banks 50 77 80 85 86 120 ix List of Tables Table 4.1 Table 5.1 Table 5.2 Table 5.3 Table 5.4 Table 5.5 Table 5.6 Table 5.7 Table 5.8 Table 6.1 Table 6.2 Table 6.3 Table 6.4 Results of empirical studies concerning the impact of regulation on bank governance Banking regulatory measures: summary statistics Banking sector and macroeconomic features: summary statistics Correlation of the main variables Baseline model results (random effects estimation) Regression results with endogenous covariates (HT estimation) Regression results for the dynamic model (RE estimation) Test for a structural break after the financial crisis (RE estimation) Results for the regressions explaining regulation changes (RE estimation) Summary statistics Correlation of the main variables Characteristics of banks in the bottom and top quartile of loan growth Estimation results for the dependent variable loan growth during the sample period 2005–14 148 184 186 188 190 191 192 193 194 220 222 224 228 xi xii List of Tables Table 6.5 Table 6.6 Table 6.7 Table 6.8 Table 6.9 Table 6.10 Estimation results for the dependent variable NPL growth during the sample period 2005–14 Estimation results for the dependent variable loan growth during the crisis period 2007–10 Estimation results for the dependent variable NPL growth during the crisis period 2007–10 Estimation results for the impact of regulatory change on loan growth during the crisis period 2007–10 Estimation results for the impact of regulatory change on NPL growth during the crisis period 2007–10 Post-crisis regulatory changes 230 234 236 238 240 243 246  Post-Crisis Banking Regulation in the European Union market funds regulation, the framework for risk transfer instruments EMIR, the framework for alternative investment fund managers directive (AIFMID), enhanced securitisation arrangements (MIFID), and the UCITS framework The new regulations may restrict the liquidity provision to the interbank markets by shadow banks and increase the costs of bank financing in the short term This effect may be pronounced, given that the EU banking sector is substantially exposed to shadow banking institutions’ financing The long-term effect of the new regulations will depend on the persistence of the alleviated costs and on the ability of shadow banks to adapt to the new requirements Also, the enhanced risk management framework and transparency of transactions with shadow banks should contribute to long-term stability benefits Two further regulatory acts, the BRRD and the DSGD, may have a beneficial impact on lending The results of the exercises above confirmed the positive impact of combined prudent supervision and deposit insurance schemes on constraining NPL. One can therefore expect that the increased supervisory power over sound and problematic institutions within the SSM and SRM framework may contribute to a more prudent lending behaviour References Adams-Kane, J., Jia, Y., & Lim, J (2015) Global transmission channels for international bank lending in the 2007-09 financial crisis Journal of International Money and Finance, 56, 97–113 Admati, A., de Marzo, P., Hellwig, M., & Pfleidere, P (2010) Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why Bank equity is not expensive Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2010/42 Aiyar, S., Calomiris, C., & Wieladek, T (2012) Does Macropru leak? 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Bank and Credit, 46(3), 207–236 Thakor, A (1996) Capital requirements, monetary policy, and aggregate bank lending: Theory and empirical evidence The Journal of Finance, 51(1), 279–324 Summary and Conclusions The post-crisis banking regulatory reforms in the European Union (EU) have provoked an intense debate among academics, supervisors and representatives of the banking industry Contrasting views emerged with regards to the accuracy and the impact of the new solutions The analysis conducted in the book shows that the new regulations entail opportunities, as well as threats, for the EU banking sector The new regulations are a response to the recent financial crisis They amend many drawbacks of the incumbent frameworks The liberalisation of the banking sectors and the change of banks’ business models exacerbated the prevalent information asymmetry, the lack of market discipline and the conflict of interests between bank stakeholders The crisis highlighted particularly the fallacies of the framework consisting of regulatory arbitrage due to the unregulated shadow banking system, insufficient regulation of systemically important institutions, the materialisation of endogenous and systemic risk, as well as deficient international coordination of regulation despite the increased international interconnectedness of banks These problems are substantially addressed by the new regulations © The Editor(s) (if applicable) and The Author(s) 2016 K Sum, Post-Crisis Banking Regulation in the European Union, DOI 10.1007/978-3-319-41378-5 251 252 Summary and Conclusions The post-crisis regulatory reforms in the EU are based on the Basel III framework The main advantages of the new Basel Committee of Banking Supervision (BCBS) guidelines are the strengthening of banks’ capital positions and their resistance to shocks, the improvement of risk management, and the enhancement of transparency, governance and disclosure in the banking industry These goals are mainly achieved through the enhanced derivatives risk management framework, decreased dependence of the securitisation regulations on external rating-based models, as well as improved risk modelling Importantly the new framework mitigates the procylicality of banking activities through the introduction of additional capital buffers Although, one has to stress, that due to the pressure of the banking industry some of the planned Basel III reforms have been watered down in the final version of the framework and the timelines of their implementation have been extended A substantial drawback of the new framework is the maintenance of the basic outline of Basel II with regards to capital requirements against specific exposures Particularly, Basel III does not solve the problem of portfolio invariance The imposition of additional capital requirements for concentrated portfolios has been postponed until 2019, hence a substantial threat is that the incumbent rules may perpetuate systemic risk Moreover, the framework still leaves room for regulatory arbitrage due to the different treatment of the trading and banking book positions and the possibility of shifting the risk outside the banking sector to evade capital requirements Controversial aspects of Basel III refer also to the insufficiently addressed large exposures treatment and the issue of sovereign risk weighting Potentially, this could lead to risk concentration and improper sovereign risk pricing The new EU regulations build substantially on Basel III, but also introduce EU-specific rules As a response to the changing patterns of EU banking integration they establish a supranational financial supervisory system consisting of the European Central Bank (ECB), European Supervisory Authorities (ESA) and the European Systemic Risk Board (ESRB) The new framework addresses the Too-Big-To-Fail problem by strengthening the supervision over systemically important banks It also improves market transparency through the common reporting framework for systemically important institutions The new CRD IV/CRR package strengthens the capital and liquidity positions of banks An advantage Summary and Conclusions 253 of the CRD IV/CRR package is that it also improves the previous versions of the directive, which contributed to the fragmentation of the EU banking system and regulatory arbitrage Since the Capital Requirements Regulation (CRR) is directly binding on the respective member states it limits the scope for national discretion The banking sector stakeholders may also benefit from the Bank Recovery and Resolution Directive (BRRD), which is aimed at restoring confidence in EU banks and preventing the need to bail out Too-Big-To-Fail institutions Several acts enhance the transparency of shadow banking regulation, which mitigates a crucial problem—the opacity of the EU-banking sector funding The confidence in the banking sector is also boosted by the reformed Deposit Guarantee Schemes Directive (DGSD) schemes Substantial opportunities in terms of strengthening the EU banking systems’ stability also arise due to the direct inclusion of bank governance elements in regulations concerning the board of directors, shareholders’ rights, remuneration policies and transparency requirements The new regulatory acts establish the basis for the creation of the banking union, one of the most ambitious and far reaching projects in the history of the EU. The banking union provides substantial opportunities for bank stakeholders since it is aimed at resolving the immediate problems relating to the sovereign debt crisis, as well as strengthening the single market for financial services in the longer term The movement of the supervisory responsibility and potential financial assistance to the supranational level is expected to reduce the fragmentation of financial markets, counteract deposit flights and to restore confidence in the EU banking sector through setting uniform standards for banking regulation within the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) Nevertheless, the new EU regulations may also pose threats to credit institutions’ stakeholders since they not fully address the ailing banks’ problems First of all, the EU rules diverge from the guidelines put forward in Basel III in terms of the crucial issue of the sovereign risk regulatory treatment The attribution of zero risk weights to sovereign bonds in capital requirements, as well as their exemptions from the large exposures treatment may contribute to mispricing and concentration of sovereign risk Moreover, banks may incur substantial costs relating to the intro- 254 Summary and Conclusions duction of the new capital and liquidity requirements The mentioned financial stability gains are conditional on whether banks will reduce their risk taking in response to the new requirements A further concern, related to the new framework, is that the incomplete banking union, as well as the regulations aimed at pooling sovereign competences, may perpetuate systemic risk Potential bank failures may easily transfer to other member countries through the joint resolution system Critics of the banking union also stress potential conflicts arising from the competing competences within the SSM between the ECB and the national supervisory authorities Potential threats are also related to the weaknesses of the SRM pillar of the banking union: its dependence on the viability of the bail-in principles and the size and effectiveness of the single resolution fund The amount of funds, which are not yet pooled within the SRM, determines largely the probability of a potential participation by taxpayers in absorbing the effects of banks’ failure A controversial issue related to the SRM construction is the prolonged duration of crisis resolution Abstracting from the long term build-up of a full banking union, the mechanisms put forward in the regulation may extend the resolution of potential crises A serious drawback of the banking union is the lack of alignment of the schedule of implementation of the SSM and SRM pillars This difference may create loopholes in the functioning of the banking union The supervision will be carried out on the supranational level, while the resolution is to some extent still a national responsibility, since the mutualistion of the fund will proceed gradually From another point of view, the new regulations are expected to improve the stability of the EU banking sector due to the mitigation of regulatory capture which pertains to country level regulations The movement of the decision making process to the supranational level could be helpful in resolving the problem of excessive influence of banks on regulations Although impediments to breaking the regulatory capture may occur due to the dominant participation of the banking industry representatives in the EU consultation processes, as well as their apparent advantage that relies on providing the most comprehensive responses to the questions posed in the consultative documents Banks, while being important contributors to the ongoing regulatory process in the EU, usu- Summary and Conclusions 255 ally argue in favour of loosening regulations Despite this fact, the post crisis regulations in the EU lack comprehensive addressing of the regulatory capture problem A frequently discussed issue is the expected impact of the new regulations on bank lending The empirical analysis conducted in the book shows that various type of regulations affect credit provision The impact of the enhanced capital adequacy stringency through the CRDIV/CRR package will depend largely on the initial capital positions of banks and the increase of financing cost triggered by the new requirements Importantly, the effect of the new capital and liquidity regulations may differ during the transitional phase of their introduction and in the long term A substantial factor of the long-term impact will surely be the persistence of the tendencies which occur during the transitional period, for instance, the widening of the lending wedges due to increased funding costs Credit growth may be also affected by the new regulations concerning shadow banking The new regulations may restrict the liquidity provision to the interbank markets by shadow banks and increase the costs of bank financing in the short term This effect may be pronounced, given that the EU banking sector is substantially exposed to shadow banking institutions’ financing The long-term effect of the new regulations will depend on the persistence of the alleviated costs and on the ability of shadow banks to adapt to the new requirements Two further regulatory acts—the BRRD and the DGSD—may have a beneficial impact on lending In the light of the performed empirical analysis one can expect that in the presence of enhanced deposit guarantees, the increased supervisory power over sound and problematic institutions within the SSM and SRM framework may contribute to a more prudent lending behaviour and increase the quality of loans Overall, the new regulations address many problems of the ailing EU banking sector; nevertheless, the still ongoing reform and incomplete banking union require further improvements to the framework in order to enable bank stakeholders to benefit fully from the new regulations and to enhance the stability of the EU banking sector The analysis conducted in the book shows that these improvements should consist, inter alia, in enhancing the risk measurement framework, particularly in terms of 256 Summary and Conclusions large exposures and sovereign risk Moreover, the new framework should align the regulatory treatment of the trading and banking book positions and counteract the possibility of shifting the risk outside the banking sector by appropriate risk weighting of non-banking activities Such measures would also help to counteract systemic risk Improvements are also required in terms of directly addressing regulatory capture to prevent the watering down of regulations This could be done through initiatives on campaign financing, limiting direct lobbying, or imposing restrictions on time periods during which employees of the regulatory authority and banking industry could not move between the two types of positions Further measures to restrict regulatory capture could include enabling regulators to reduce their excessive reliance on the data and information provided by the industry In order to limit the constraining impact of the new regulations on credit provision the framework should offer solutions that allow banks to adjust to the increased funding costs Particularly, the framework should align capital and liquidity requirements, as well as the regulatory treatment of liabilities under the BRRD in terms of implications for shortterm and long-term bank funding costs The most challenging reforms concern the need to complete the banking union, primarily the synchronisation of its respective pillars, to avoid the imposition of resolution costs on the public To ensure the functioning of the resolution tools, the framework should put forward the need to prepare detailed recovery plans for international banks with regards to the ring-fencing of those subsidiaries which are sustainable independently of the group Moreover, the completion of the banking union is also necessary to counteract the build-up of systemic risk To limit the propensity of the EU to asymmetric shocks, induced by the pooling of sovereign competences, the new framework should provide tools which would counteract such shocks Since through the joint resolution system bank failures may easily transfer to other member countries, the new regulations should be accompanied by some additional supervisory and fiscal backstops at the national level To strengthen the supervisory and resolution mechanisms and to increase the legitimacy of the banking union the completion of the respective elements of the project should proceed synchronically Index A activity regulations, 18–20, 214–15 agency theory, 12–14, 145 Alternative Investment Fund Managers Directive (AIFMID), 100 asset quality requirements, 20–1, 147 auditing requirements, 20 B bank governance, 23, 133–63 banking book, 43, 53, 62, 110 banking union, 95, 102–3, 119–26, 162 Bank Recovery and Resolution Directive (BRRD), 95–7, 104, 105, 121, 199–201 Basel I, 41, 62 Basel II, 52 Basel 2.5, 44, 52, 58 Basel III, 41–72, 91, 109–12, 118, 174 Better Regulation Guidelines, 171, 172 board of directors, 95, 134 BRRD See Bank Recovery and Resolution Directive (BRRD) C capital requirements, 16–18, 67, 182 Capital Requirements Directive (CRD), 89, 103, 123, 155, 197 Capital Requirements Regulation (CRR), 93–4, 104, 117, 158, 198–9 central counterparties, 100 chief risk officer (CRO), 138 comprehensive risk measure, 58–60 © The Editor(s) (if applicable) and The Author(s) 2016 K Sum, Post-Crisis Banking Regulation in the European Union, DOI 10.1007/978-3-319-41378-5 257 258 Index corporate governance, 6, 92, 133, 144, 175 CRD See Capital Requirements Directive (CRD) credit risk, 4, 26, 41, 58, 109, 201 credit valuation adjustment, 60–2 CRO See chief risk officer (CRO) CRR See Capital Requirements Regulation (CRR) D de Larosière report, 87 delegated monitoring, 4, 13, 134 Deposit Guarantee Schemes (DGS), 82, 97–8 Deposit Guarantee Schemes Directive (DGSD), 97–8 deposit insurance, 3, 21–2, 82, 112, 175, 210, 232 deregulation, 5, 144, 182, 196 determinants of regulations, xvii, 169, 182 DGS See Deposit Guarantee Schemes (DGS) DGSD See Deposit Guarantee Schemes Directive (DGSD) dividend policies, 135, 142–3, 152 E EBA See European Banking Authority (EBA) EDIS See European Deposit Insurance Scheme (EDIS) EFP See employee financial participation (EFP) EFSF See European Financial Stability Facility (EFSF) EFSM See European Financial Stabilisation Mechanism (EFSM) EMIR See European Market Infrastructure Regulation (EMIR) employee financial participation (EFP), 156 endogenous risk, 29–32 entry regulations, 16 ESRB See European Systemic Risk Board (ESRB) European Banking Authority (EBA), 88, 104, 111 European Deposit Insurance Scheme (EDIS), 107 European Financial Stabilisation Mechanism (EFSM), 77 European Financial Stability Facility (EFSF), 77 European Market Infrastructure Regulation (EMIR), 100 European Systemic Risk Board (ESRB), 66, 88 expected exposure at default, 57, 58 Expected Shortfall, 47, 52 F FCD See Financial Conglomerates Directive (FCD) Financial Conglomerates Directive (FCD), 99, 202 Financial Services Action Plan, 82 Index I impact assessment, 170–4 incremental risk charge (IRC), 58–60, 65, 109 information asymmetry, interbank market, 8, 26, 64, 76, 102, 124 intermediary function, 4, 24 internal ratings based approach, 42 IRC See incremental risk charge (IRC) L large exposures treatment, 53, 62, 72, 110 LCR See liquidity coverage ratio (LCR) lender of last resort (LOLR), 21–2, 36, 84, 125 Liikanen report, 87 liquidity coverage ratio (LCR), 48, 94, 117, 244 liquidity provision, 1–3, 20, 210, 246 liquidity requirements, 20, 94, 244 LOLR See lender of last resort (LOLR) loss given default, 58 M Markets in Financial Instruments Directive (MIFID), 91, 100 maturity mismatch, 1, 20, 31, 134 MIFID See Markets in Financial Instruments Directive (MIFID) 259 money market funds, 5, 26, 63, 100, 201, 245–6 moral hazard, 8, 21, 46, 134, 175, 216 N net stable funding ratio (NSFR), 48, 94, 117, 244 non-performing loans, 3, 21 NSFR See net stable funding ratio (NSFR) O Ordinary Legislative Procedure, 170 OTC derivatives, 9, 12, 47, 63 P portfolio invariance, 43, 51, 60–2 pressure groups, 177, 184, 197 private interest theory, 175, 184, 196 probability of default, 42, 57, 61 public consultations, 172 public interest theory, 175, 182, 195 R regulatory arbitrage, 25, 44, 69–72, 89, 126, 158, 245 regulatory capture, 122, 172, 197, 255 regulatory dialectics theory, 145, 175, 181–2, 189 remuneration, 91, 139–42, 157–61 resolution, 22, 77, 95–7, 121, 200, 201 260 Index risk management, 2, 10, 45, 71, 92, 135, 246 risk weights, 42, 65, 94, 109, 152, 199 S Second Banking Directive, xiii, 81, 83 Securities Market Program, 80 self-regulation, 10 shadow banking, 5, 25, 52, 70, 100–2, 197, 201–2 Single Resolution Board, 106 Single Resolution Mechanism (SRM), 103, 121, 246 Single Rulebook, 88, 103 Single Supervisory Mechanism (SSM), 103, 122, 246 sovereign bonds, 48, 75, 109, 114, 253 sovereign debt, 66, 102 sovereign risk, 53, 62, 109–12, 252 spillover effects, 12, 26 SRM See Single Resolution Mechanism (SRM) SSM See Single Supervisory Mechanism (SSM) stress tests, 21, 57, 89, 105, 111 supervisory colleges, 33, 49, 90 systemic crisis, 10, 114, 122 systemic risk, 8, 29, 61, 112–14, 176, 201, 251 T Tier I capital, 16, 41, 46, 63, 94, 111, 161 Tier II capital, 16, 46 Too-Big-To-Fail, 27–9, 95, 252 trading book, 44, 91, 110 Transparency guidelines, 161–2 Troika, 77 U undertakings for collective investment in transferable securities (UCITS), 100 V Value at Risk (VaR), 42, 53–4 .. .Post- Crisis Banking Regulation in the European Union Katarzyna Sum Post- Crisis Banking Regulation in the European Union Opportunities and Threats Katarzyna Sum... Complement of Banking Regulation? 133 The Factors Influencing the EU Banking Regulatory Framework: Impediments for the New Regulations 169 Banking Regulation and Bank Lending in the EU 209 Summary... the role of banking regulations within the framework of the agency theory It points out the purpose and functions of the respective elements of banking regulations and their importance in maintaining