The deliberate and systematic tightening of regulation around the world is shrinking the size and scope of banking activity, leading to the proliferation of alternative and less transparent lenders.
Regulators and governments have turned – or are turning – their attention devising new ways to regulate each of the many different, individual financial activities. The result is a welter of new rules and a tide of massive change, which is likely to have much wider economic impacts, according to the British law firm Allen & Overy in a research report released on December 6.
The effect of the most important regulatory changes focus on one main issue – the imposition of much higher capital requirements for banks and investment firms, with particular emphasis on global banking institutions, which are systemically-important.
This will, as a result, have negative implications on credit markets throughout the globe.
“Our view is that the impact of regulatory reform is disabling, rather than enabling, the flow of credit in the global financial system,” said Alistair Asher, head of the financial institutions group at Allen & Overy. “In the longer term it could substantially damage areas of financial activity that are understood and manageable, giving rise to a new breed of finance that is altogether less controllable and more unpredictable.”
The “new breed” of finance includes the recent proliferation shadow banking activities, especially as banks quit areas now considered too burdensome or non-core.
Additionally, other issues compound the situation. Leverage ratios and liquidity buffers will further constrain banks’ options. Securitisations, the traditional lifeline of bank funding, are also being made more difficult to create and will receive less beneficial treatment.
“Structural changes separating trading and other investment activity from traditional banking – and/or ‘ring-fencing’ bank deposits – will have a huge impact, proving costly and disruptive not just for universal banks but for all those banks inadvertently caught in the crossfire,” said Asher.
These changes come in many guises. They include Basel III, Capital Requirements Directive IV, the Recovery and Resolution Directive, the Independent Commission on Banking (UK), the EU’s Liikanen Report, Dodd-Frank, European Market Infrastructure Regulation (EMIR), Alternative Investment Fund Managers Directive (AIFMD) and the Financial Stability Board’s shadow banking review, adds the law firm.
All these new regulations will have an adverse impact on Asia.
“Asian countries are struggling with the consequences, intended or otherwise, of what are seen in many respects as Western developments at the core, and what that means for them domestically and in the context of their competitiveness in the region and beyond,” said Alan Ewins, Asia Pacific head of regulatory at Allen & Overy.
Policymakers will need to take a long, hard look at the cumulative effect of this massive regulatory reform agenda.
In particular, the authorities must consider what steps they can take to free up the provision of beneficial credit – whether from traditional or alternative sources, says Allen & Overy.
“If they fail to take a radical approach to this issue, we believe business will continue struggling to access finance, with clear consequences for broader economic growth,” said Asher. “Companies worry about the cost of credit, its availability, its terms and the speed of execution.”
While terms have not changed fundamentally the squeeze on credit availability means companies are having to consider a wider range of financing options.
This is starkly demonstrated through global high yield bond issuance reaching US$110.3 billion in the third quarter of 2012, the highest quarterly level since records began in 1980, highlights Allen & Overy.
Other tactics being employed across markets include “amend and extend” deals in leveraged finance, a noticeable increase in private placements in bond markets, the use of covered bond structures and export credit agency (ECA) guarantees for bond issues in asset finance, as well as insurers and fund managers stepping in to fill some of the gap in real estate and infrastructure finance, adds the law firm.
Banks provide the bedrock
Despite the volume of change in prospect, banks will still be the pivotal players in structuring large, complex financial transactions, where multiple pools of capital need to be accessed.
Financial institutions’ balance sheets are being restructured but remain very substantial, with assets growing by 25% in the past five years, says Allen & Overy.
However, the volume of legislation seems disproportionately large and the scope for differential national implementation and extraterritoriality is immense. The rules are overly complex and lack the coherent design needed to facilitate an orderly flow of credit.
“They ignore the fact that the financial crisis was actually sparked by institutions failing to observe very simple rules of prudence and risk management, and by central banks increasing the supply of cheap money,” said Asher. “Both led to a mispricing of risk more generally.”
“There is now an inherent contradiction between many governments’ desire to remove risk from the system and their insistence that banks should lend more,” he added. “In any downturn there are fewer creditworthy borrowers and an insistence that banks lend to struggling businesses may increase risk in the system.”
As a result, policymakers face a crucial choice here and that is making the financial system extremely safe in the name of financial stability that it is “unworkable and creates paralysis”, or accepting that a functioning financial system carries a degree of risk and should be promoted as such, notes Allen & Overy.
“While paralysis in the system may eventually create opportunities for some new players to emerge, it will be a slow process rather than a sudden switch,” said Asher.