How do you see the state of liquidity in European bond markets and can anything can be done to cushion shocks more? Or is lower liquidity a necessary trade-off to make the banking system safer?
What you see in the markets is the consequence of some major changes over the last three years. Liquidity has gone down because banks have deleveraged, derisked and refocused their business models on core areas. They have exited certain markets in response to high capital requirements — many are not as dominant in market-making as they once were.
UBS is one example, we have scaled back some of those activities.
There is also a shift in trading patterns. More and more trading is moving to centralised clearing and electronic platforms and that is impacting market activity. What we’re also seeing is a high liquidity concentration in repo markets and an increasing demand for liquid assets. Central banks are acting as buyers of last resort and the assets they buy are being taken out of the market. So what used to be high quality, liquid assets available in the market are now sitting on the central banks’ balance sheets in buy to hold positions.
Markets now have to get used to more conservative liquidity planning, to more volatility and to a situation where liquidity is scarcer.
The long term funding and liquidity ratios are very indicative of the fact that banks should manage liquidity conservatively.
But I think there are some risks around liquidity. So far the regulators have not seen it as an area where they need to act, despite some episodes in the market when liquidity has been scarce. But if we keep having more episodes like we’ve seen in the Bunds market or in the Treasuries market last year — and it’s likely that we will — the issue will be back on the agenda for regulatory discussions. Scarce liquidity is a side-effect of re-regulation, and the side-effects may become more pronounced as monetary policy is normalised and liquidity in the market changes.
Can we have more regulation and less volatility or is there no happy, middle ground?
There are certain areas where more responsive regulation could take out some sharp edges. For example, a lot of liquidity is missing as a result of the securitization markets largely disappearing from Europe. And I’m not just talking about complex securitizations — even plain vanilla securitizations have disappeared. Thankfully we are now seeing initiatives by the ECB and the Bank of England to restart liquidity in plain vanilla securitizations.
Simple, well-structured securitizations in the hands of the right investors can be great sources of liquidity for the markets. And let’s not forget: not having securitization means all the exposures end up sitting on banks’ balance sheets.
In terms of finding a middle ground, by adjusting some of the extreme regulatory requirements and differentiating more between plain vanilla and complex derivatives, we may be able to reconcile having more regulation with less volatility.
Does the fact that the European securitization market is small and weak while the US market is in rude health indicate a failure to co-ordinate international regulation?
The first round of re-regulation in the direct aftermath of the financial crisis was largely co-ordinated and happened under the umbrella of the Bank for International Settlements. I was part of that effort and it was well executed. We created an international level playing field with Basel III, with new capital requirements and harmonised liquidity standards. There was a co-ordinated attempt to establish resolution and recovery regimes and the leverage ratio.
But what we’ve seen over the last year and a half are nationalised standards for regulation — first and foremost in the US, but also in the UK and here in Switzerland.
Even the Financial Stability Board agenda now allows for ‘national finishes’ as part of the international regulatory discussion. For example, in the debate around TLAC [total loss-absorbing capital], there might be a minimum standard and then additional requirements in some countries, above that minimum.
These national add-ons make it much more difficult to have a level playing field and represent a negative trend. Regulatory arbitrage becomes the seed for the next problems in financial markets, because financial markets’ main function is to arbitrage differences in returns. The risk is that arbitrage in the quality of products and regulatory standards cannot be prevented.
This risks that the weakest international standard becomes the most attractive for weakly regulated entities and weakly designed products.
A level international regulatory playing field is absolutely desirable as it stamps out regulatory arbitrage. It can help to reduce certain activities which, from a macroprudential standpoint, are undesirable.
Like prop trading?
Yes, as an example. We stopped having proprietary positions at UBS because of the very high capital requirements. Our trading is now focused on executing client orders.
If regulation means these activities do not earn a medium-term return over the cost of capital then they will disappear. But regulation has to be truly global for it to work for the good of the whole global banking system.
We need to mention also the complexity and cost of regulation. We now receive roughly 60,000 regulatory acts, orders and legislations every year, which creates a huge fixed cost for the bank and a major hurdle for new competitors to enter the market. This, in my view, undermines competitiveness in some of the core markets where the ultimate user of financial services would benefit from more competition, rather than less.
In some markets in the US, the top five banks have a market share of around half. In other European markets the concentration is similarly high. And that’s the core of standard banking services.
As for the fintech space where non-banks are coming in, it provides for a very competitive environment because they are not initially regulated. But if you fast forward a few years, as regulation is rolled out to those markets there will be a much higher cost of entry for new players.
So have we done the best we can, given the complexity of pushing through global regulation? Or have we failed?
I have supported most of the re-regulation from the start. The new regimes for capital standards, liquidity planning and resolvability have been adequate measures.
Capital requirements have grown by a factor of seven compared to the pre-crisis period; this is not my number — Mark Carney mentioned it recently. So banks have become a lot safer, less complex, less risky, more cautious and better managed in terms of prudent liquidity management.
But although there was a commitment by the Financial Stability Board to end the major re-regulatory initiatives by the end of last year, I’m concerned that there are still a lot of additional regulations in the pipeline that will even further increase capital requirements.
The review of the trading book, the application of more standardised risk models for capital purposes, the additional capital requirements from gone concern rather than going concern capital, the whole TLAC debate — all of this spells more capital for the same set of banking activities.
This will have a big impact on banking in general, in particular on profitability.
Regulators at some point have to strike more of a balance. We have to focus again on running the bank, rather than changing the bank, which we’ve done now for years — especially here at UBS.
No one doubts that initiating re-regulation was necessary, but there is probably a level at which it will undermine the ability of the financial system to play its intermediary role. It will lead to disintermediation, but a completely disintermediated system is only possible if you can put a capital market system in its place. That is something the US has had from the start, so there the re-regulation of banks has a less significant impact on the economy than in Europe or in many emerging markets, where 70% of investment is financed through banks.
Do you think that explains why the US banks are so strong compared to the Europeans at the moment?
No, the US banks have benefited from two major effects. The first was a very strong rebound of the US economy, as a result of monetary and fiscal stimulus but also a very flexible job market.
The second element is a very strong financial system, which was fixed immediately after the crisis and therefore functioning quite well again in the aftermath of 2010, when Europe was hit by its own sovereign debt crisis and when many emerging market economies felt the delayed fallout of the global financial crisis.
The US is now in a cyclical lead position among all the major industrial countries, and that position (the US will grow at about 3% or above this year) means its banks will benefit from the better macro environment. European and emerging market banks are still in a more fragile situation.
In addition, the US has seen a capital market boom on the back of cheap liquidity. There was a three year continuous boom in US equity. Although we’re now seeing a market correction, that has helped the banks, in particular the large international US banks who are active in the capital markets.
In Europe you haven’t seen a similar dynamic. It has happened to some degree this year, and in Japan as a result of QE over the last two years, but the US has been in a more favourable cyclical position and with a stronger capital market for some years now. The US is also the only economy which is now way beyond its pre-crisis peak in terms of GDP; GDP is up 7% relative to 2007-08. The stockmarkets are up, many economic indicators have well surpassed the pre-crisis peak. In Europe only Germany is in a similar position. Europe’s GDP is still roughly at the level it was in 2008. In some countries like Italy, GDP is back to the level where it was in 2000.
If you look at banking as a global industry Europe has sunk further away from the US. Is that a problem for Europe?
No. Among the European banks we as a global Swiss bank are leading in many dimensions, be it capital or liquidity. We are closer to and in many aspects even ahead of the US standards and other continental European banks.
But it’s true the US banks have had a very strong last three or four years. The European banks haven’t been helped by the fact that they have gone through a second crisis that didn’t happen in the US — the European sovereign debt crisis.
Europe is in quite a different cyclical position. With such different home markets and market developments it’s not surprising some European banks find it harder to cope with the re-regulation and to be ahead on international standards, compared with their US peers.
You mentioned fintech. Does UBS see it as a threat?
We don’t see fintech just as a threat. First of all, digitalisation is for us an intricate part of any future success story in the banking industry.
Consumers have got used to real time solutions, served to them in a simple way, any time, anywhere and through many channels. We have to be a central part of that development.
We have invested roughly $1bn over the last few years in new technology, and roughly one third of UBS is a tech company by now. We use these technologies not only in retail banking, where mobile payment services are now a standard offering, but also in wealth management, where clients can access our services through mobile devices.
Merely by adopting new technologies, banks cannot outperform the new players, many of which are not banks. But by combining the client relationships we have with expertise in technology, we can provide an offering that I think is superior to what some disruptive or new players can offer. For us, that is the perfect combination of ‘high tech and high touch’.
On the other hand, these new technologies are not just opportunities. Like every business opportunity they come with risks, such as cyber threats, and in my view they pose tough challenges for the banks.
Because they — the crowdfunders, P2P platforms, direct lenders — are not regulated as stringently as banks?
Global, consistent regulation is clearly necessary. For example, when Alibaba offered its payment services in China, it was like a cash deposit, but offered a multiple of the returns Chinese banks were offering, and it grew very fast.
To some degree, these forms of new funding are unregulated and will always be unregulated as they start up. There will be a point, though, where regulation sets in. It should be very clear that when similar activities — whether lending from banks or peer-to-peer — reach a certain level, they should face the same type of regulation.
We are heavily investing in some of these fintech areas. We have an incubator hub in three locations which develops new technologies and applications. Even if only 10% of them ever make it, that is a very good rate at which you can invest in a broader future offering.
A lot of the smaller German and Swiss banks are fairly passive deposit and asset takers. Are they the kind of institutions most at risk from these fintech challengers?
I don’t see that these more basic services of traditional, broad-based institutions like the German and Swiss savings banks will become less attractive over time.
I am convinced clients will always use branches. The larger institutions have the advantage of broad branch networks, and while future generations will probably use more multichannel access to banks, it is an illusion to think that branches will disappear.
There will always be room for these types of institutions to offer simple services in a broad set of locations and combine them with simple multichannel access, like mobile payment applications, which all these institutions have. They are able to offer rock bottom pricing which will always be attractive to some consumers. As long as they stay on top of these multichannel developments, these banks can continue to be successful in their own right.
More sophisticated clients, more affluent clients, our high net worth and ultra-high net worth clients for example, will want to have a close relationship with client advisers and be willing to pay for that relationship and quality of services. So there will always be a continuum of opportunities.
We’ve talked of the strength of US banks. Do we need to see bank mergers in Europe again to make the system stronger and more competitive with US institutions?
Bank mergers absolutely would go against the grain of regulators’ philosophy of ‘too big to fail’. They think some of the global systemic banks are already too large, and I have a hard time imagining that a European regulator would agree to a merger of two banks — who, in their own right, are already systemic — to form an even larger bank.
Absent such growth, in a period where revenues are challenged, there can be a lot of benefits achieved through cost-cutting. Focus on the cost side is what we all do now, as the revenue side of the business is limited by the macroeconomic environment and re-regulation.
We might see some large institutions buying much smaller, specialist institutions that fit their criteria perfectly. But I don’t really see any appetite among regulators to agree to any M&A among the major banks.
The sovereign crisis has been a drag on European growth. Are you satisfied with the Greek solution?
If I go back to December last year, before the current Greek government came into power, we at UBS had closed our overweight position on US equities, because we felt they had had a long successful run and that, with monetary policy normalisation on the horizon, it was unlikely there would be a lot of additional dynamics in US equity markets.
We moved our equity overweight to Europe. We felt Europe was still priced to crisis levels and at some point the region would gain strength, in particular against a background of QE.
Those unconventional policies bear, in my view, enormous long term risks, but they provide short term economic stimulus and, in particular, a very favourable equity environment, which helps equity and other risky assets to rally, while the returns of fixed income assets are pushed down.
Now, over the last half year, despite all the back and forth negotiations with Greece, European equity dynamics have actually been pretty positive, at least until the correction in August.
During that period, when there was a major pushback from the Greek government, my view was that the crisis would blow over, and I voiced that frequently. I also said that what Greece needed was a government that would implement the reforms agreed with the international creditors.
I never felt there was any risk that negotiations would fail, because the politics were very clear — a compromise would be found.
Even with the finance minister saying the opposite at the time?
Yes. Europe has always gone through these phases of major uncertainty, with everyone talking out of line and out of sync. That’s just something you’ve got to get used to when you see how Europe arrives at a position. The public disputes and engagement in finding a solution are part of how Europe has dealt with this crisis resolution from the start, both in the central banks and in the public arena.
Despite the public referendum that showed more people in Greece than not were against the bail-out? Are you not discounting democracy?
No, as always with referenda, it depends on the question asked, and the question was whether people liked those restrictive policies. Wherever you ask that question, the majority of people experiencing a severe adjustment, would answer that they don’t like it. But at the same time, for the last 10 years there has been very broad support in Greece for remaining in the euro and being part of the European project.
The rest is political noise and manoeuvring which brings with it uncertainty and volatility and we’ve always had that — it’s part of how democracies function. This can unsettle investors who like rational quiet solutions and to be reassured that everything will be all right. But ultimately Europe has always been able to find a solution and I’m very sure this will continue to happen.
While the current market correction and some of this saga around Greece has been like a dragging anchor for European growth, it will slowly disappear. It will also fade from the news as the US recovery gains momentum.
What about the Chinese correction — are people worrying too much?
The correction in China had to do with the re-orientation from export-oriented to more domestically driven growth. It is also linked to the opening up of the Chinese financial markets for international investments. In the first half of the year that led to a massive boom in Chinese equity markets because investments rotated from property to equity and international investors flooded into the stockmarket.
Thanks to the Shanghai-Hong Kong Stock Connect, investors can put money in but can now also get it out. This meant the correction was stronger than pre-liberalisation. So I’m not deeply concerned; it was a correction after an excessive period of markets going up.
Medium to long term, I’m pretty confident about China and emerging markets in general. The gravity centre of global growth over the next couple of decades will continue to move east from the mature economies to emerging economies, and China is going to play a leading role. I’m pretty confident they will be able to establish growth at above 6%.
As long as they grow twice as strongly as the US, even if they’re only half the size of the US economy now, they will still catch up and be the dominant contributor to world growth.
However, being a wealth management institution that prudently works with clients on long term investments, I wouldn’t go as far as to say that the current market correction is at a point where you should now increase your exposure to emerging markets.
Emerging markets are undergoing the typical correction that we saw in 1994, 1997-8, in 2002, in 2004-5. Whenever US monetary policy is at a turning point, capital flows that benefited EM for as long as the US had very low interest rates reverse.
It’s worth noting that the US turnaround in monetary policy has happened cautiously so far, and this has actually helped the emerging market adjustment. But it’s also very clear that this adjustment in emerging markets, from the turning point onwards, will continue for the next couple of quarters, hopefully in an orderly fashion, because investors have been positioned for this for quite a long time now.
Is there a danger of unconventional policy becoming conventional, and how hard is it going to be for Europe to come off the QE laughing gas?
It’s going to be very difficult, not just for Europe but for everyone. Global liquidity is now at an extraordinary, unprecedented level. Even the Fed is being very cautious in raising rates. The problem with liquidity is that it doesn’t matter much whether it is generated in the US, Europe, Japan or through additional easing now in China. Financial institutions spread that liquidity around globally.
I think the US economy is ready for the Federal Reserve to start raising rates. The risk is that with Europe and Japan still massively easing we may see continued booms in the stockmarkets and strong declines in the currencies.
The euro has already come down quite substantially against the dollar and that has provided a tailwind for European exports and growth.
Of course, the interest rate and credit channels do not work well in economies where rates are at zero and credit demand very low. The major transmission of monetary policy is through the exchange rate channel and the wealth channel. That is highly redistributive, unlike the credit or interest rate channels. An exchange rate-driven growth in exports benefits the country that has the easy monetary policy, but doesn’t benefit other economies.
So I do see an incentive problem for central banks to end QE, because it provides a beneficial tailwind for their economies.
Another issue that would make an early exit from these policies less likely is that they have become a substitute for reforms, rather than a complement to them. They were originally designed to buy time; that time has not been used by many countries though.
The ECB’s policy has set the wrong incentives for many countries, who now live on cheap cash because the economic benefits of loose monetary policy provide them with a window for postponing reforms that are politically very unpopular. Greece is a prime example.
A similar issue arises in Japan. We’ve seen massive fiscal and monetary easing, but the third arrow, reforms, has not hit the target — we’re still waiting for reforms to make the economic recovery sustainable in the long term.
Summing up, I do think these policies bear a certain amount of risks. Perhaps the biggest is that the more they are applied, the less they are effective, and the more risk they have of more dramatic consequences.
So where are the bubbles you’re worrying about?
We’re just seeing one of them correct: a major equity boom that was liquidity-driven, rather than driven by fundamental valuations, first in the US, where the market had the longest run, and to some degree now in Europe, Japan and in China.
M&A is in a very high dynamic in the US again, and the whole area of financing it is something we need to look at vigilantly, in particular leveraged finance.
Do you agree with the leverage cap in the States?
While our own risk management in that area was prudent, it appears that not everyone’s was. If it had been, the US regulators wouldn’t have imposed such caps.
I also worry about the Swiss housing market, because we’ve seen a very strong, year-long credit boom, partly driven by fundamentals like immigration and low interest rates.
I tend to look at the markets that have had the most dynamic developments over the last two to three years as the ones vulnerable to the biggest correction, and among them is clearly housing finance.
How important is Capital Markets Union?
I’ve been pushing it quite vocally. I believe very strongly that it should be an open Capital Market Union, not one that solely eliminates internal barriers to capital flows but one that also opens the EU to global capital markets.
I fear the Europeans, in their typical bottom-up design, are not putting in place an SEC-like capital market regulator that has the teeth and power to drive the project forward.
ESMA [the European Securities and Markets Authority] with all these regulators sitting around the table is not fully set up the way a good dynamic European SEC-like regulator would look like. Weakly regulated markets are fragile, so I’m very concerned that they’re making the mistake of not putting in place an ambitious fast track agenda.
Via the Swiss Finance Council, our lobbying arm in Brussels, we try and get involved in these discussions as they are shaped. Our experience in Switzerland has been that we want to be part of the discussion from the start before everything is written in stone and cannot be changed any more. We want to be part of the discussion from the start. We are also global banks, so we’d better try to influence the European legislation while we can.