How can security markets finance long-term growth?

Brussels

1 October 2013

Diego Rodriguez PalenzuelaCapital Market and Financial Structure Directorate Monetary Policy

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Motivation

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- The post-crisis regulatory landscape should address the pitfalls that led to the 2007-08 and 2010-12 financial crises, based on the analysis of their causes.

- Yet, worries have been voiced whether the transition costs could hamper the on-going recovery, so that the transition to the new (better) equilibrium may be more protracted and painful than foreseen.

- As a case in point, a scenario of frontloading by banks of capital requirements has materialised. Observers claim that frontloading by banks of capital requirements has had a contractionary impact on output.

- However, looking through the transient impact of banks’ recapitalisation, higher capital ratios should bestow resilience to the medium term growth outlook

We focus role of securities markets for enhancing resilient LT funding

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Scope: the banking regulations considered

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Legislative situation Main components Where do we stand?

Min CET1 ratio

Capital conservation buffer

Phase in of deductionsReweightingG-SIBs surcharges

Leverage Passed (CRD IV) implentation in 2018

LCR

NSFR

SecuritisationBCBS: 1st proposal in Dec. 2012. Final global standards to be issued by the BCBS in 2014.

Change in the risk weights and capital requirements

Increased standardisationEstablish margin callsFavour CCP

Ring-fencing of retail and investment activities

Capital and liquidity requirements at the level of each unit

Transfer across units at market prices

First proposals known and under discussion.

Implementation to determine. Final

outcome uncertain. Looking forward, the

effects could be substantial for

securitisation and structural perimeter.

OTC derrivatives

Preliminary analysis - Impact studies ongoing at the BCBS level

Structural perimeter

Liikanen report in October 2012. EC issued a consultative paper in May 2013. 1st legislative proposal by

end 2013.

Capital requirements

Passed (CRD IV) implementation 2013-2018.

A lot of progress made well ahead of the

regulatory phasing-in arrangements

(frontloading) - still, several banks are

under restructuring schemes and even for the others, the tail of the distribution has

some gaps to fill.

Liquidity

Amended in January 2013 by the BCBS - LCR already in CRD IV

(implementation 2013-2018), NSFR will follow (implemnetation in 2018)

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Channels whereby bank adjustment affects activity

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- Higher capital requirements usually met through more earnings retention, equity issuance and/or deleveraging and risk weight optimisation

- Liquidity requirements: Should lead to higher quality assets and better matching of asset-liability maturities, but also to lower net interest income when yield curve upward sloped and potentially also more reliance on central bank funding

- OTC derivative: Collateralisation is expensive

- Banking separation: tends to limit the economies of scale between activities

In the transition to a new steady state, adjusting to new regulation is likely to be detrimental to bank income; banks charge higher margins and tend to tighten provision of credit (e.g. Berrospide and Edge (2010), Francis and Osborne (2012), Maurin and Toivanen (2012))

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Sources: ECB computations based on BCBS (internal version of the Basel III monitoring exercise, September 2013. Note: Unpublished and confidential

Liquidity requirements ratiosCapital requirements (% RWA)

- Important progress since end 2010: banks have frontloaded.- Distribution matters. Looking through the banking sector – and

excluding the part under restructuring scheme – some gaps remain.

- More recently, the attention has turned to the leverage ratio as some suspicion as emerged around the calibration of risk weights.

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Progress made regarding capital and liquidity requirements

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Did benefits already materialised?

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CDS spread to sovereign and Tier 1 capital ratio

Some positive effects of the increased confidence in the banking system could have started to materialise with lower funding cost (lower liquidity risk and default risk)

Indeed, negative relationship between solvency ratio and CDS spread would suggest that higher capital ratios are associated to lower funding costs.

These effects are difficult to capture with structural models (unless banks can fund themselves directly on the non-deposit margin). Previous analysis may overestimate the costs.

Source: ECB computations based on DATASTREAM, listed banks. Note: CDS spread from the 5 year sovereign bond averaged over 12Q2-13Q2 (LHS) average over the first two quarters of 2013 reported to the average in 2009 (RHS).

-120

-80

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0

40

80

-4 -2 0 2 4 6 8 10 12

Change in CT1 capital ratio (p.p.)

Ch

an

ge

in s

tock

pri

ce (

%)

Change in capital ratios and in stock prices

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Direct tapping of the market by corporations

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Source: ECB estimations. See Maurin (2013)

to NFCs loan growth

to NFCs debt issuance

Contributions (de-meaned annual rate of growth in percentage, contributions in percentage points) to investment growth

Loans affected by weak overall demand and specific factors entrenched in the banking sector (regulations, funding, risk…).

Strong debt issuance activity party resulting from adverse access to bank loans from end 2011 until beg. 2013. Possible substitution. But largely resulting from idiosyncratic factors (large corporations in a few countries).

Adverse credit environment exerts an overall negative impact on business investment.

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Key factors for enhancing securities markets

• Conjunctural

• Structural

• Adverse selection

• Transition to new regulations

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• Information infrastructure

• Taxes and legal harmonisation

• Better instruments

• Ratings

• Development banks

• “Steady state” regulation

[ Shorter term ]

[ Medium term ]

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Information infrastructure

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- Problems in accessing quality information remain major barriers for better capital market funding , in particular of SMEs

- Part of these challenges have been mitigated through the use of scoring companies and credit registers …

- … and the establishment of the European Data Warehouse, [banks have been required since January 2013 to provide loan level information on SME securitisations, in accordance with a standardised template, as a necessary condition to be eligible as collateral for Eurosystem credit operations]

- Improving the transparency and quality of SME loan data – including on loan performance – would support investor confidence and provision of capital market funding, especially of SMEs

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Higher harmonisation of key legal procedures

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- Need to give priority to the longer-term goal of achieving better integrated capital markets

- Currently European equity markets are relatively small and fragmented and the cross-border ownership of corporate bonds is also underdeveloped

- Fostering the integration of European equity markets will require inter alia a higher harmonisation of insolvency legislation

[See Andre Sapir and Guntram Wolff (2013) The neglected side of banking union: reshaping Europes Financial System; note for the Informal ECOFIN 13/14 September 2013, Vilnius ]

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Reviving securitisation markets

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-Securitisation markets can provide an additional source of funding for banks, affecting positively their capacity to finance economic growth, but since 2008 confidence in the securitisation industry is damaged

-This is as a major constraint on SME access to finance: AFME estimates that ca. €200‐300 billion of funding could be provided through securitisations sold to third party investors, including insurance companies, pension funds, banks and others

-Reviving the securitisation market in the EU requires achieving the right balance between financial stability and the need to improve maturity transformation by the financial system

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Estimating the impact of the regulatory change envisaged for securitisation

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EA net flow of ABS: 200 billions in 2006 (mostly RMBS, housing loans), around 20% of new loans granted to the non fin private sector.

Increase in average risk weight, from 70% to 90% (under RBA, one approach), and in minimum capital requirement, to 7%, with implications for bank capital

Distribution of ABS held by European bank by rating (%)

Impact on risk weights of the regulatory change (%, 1 year LHS, 5 years, RHS)

Sources: ECB computations based on BCBS, Dec. 2012 and JPM

Sources: ECB computations based on JPM

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Very difficult to disentangle the contributions of demand, policies and regulatory changes on actual credit outturns

A large part of the capital and liquidity adjustments has already occurred. In addition, some positive effects appear to already be materialising

Regulatory uncertainty remains harmful and to be avoided

Looking forward, a key challenge remains in aspects affecting the banks’ funding side (e.g. ABS and shift to secured funding);

Clear scope to improve scope for securities markets for SMEs through a variety of instruments

Concluding remarks

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Thank you for your attention

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