Regulation: New rules promote a shadow banking system

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By:
Peter Lee
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Basle III unpopular with bank bondholders; Regulators insist system will be safer

José María Roldán, director general of banking regulation at the Bank of Spain and chair of the standards implementation group of the Basle Committee on Banking Supervision

"We lack a lot of information on the shadow banking and financial system and it may be difficult to disentangle the interconnectedness to the regulated system"

José María Roldán, Bank of Spain

Last month José María Roldán, director general of banking regulation at the Bank of Spain and chair of the standards implementation group of the Basle Committee on Banking Supervision, spoke to Euromoney at a seminar in London on Basle III: The rules. Those attending, mainly investors and bankers as well as some policymakers, voiced many worries.

As the European Commission prepares to convert Basle III into a draft of CRD IV to be debated and approved by the European parliament later this year and then enacted into national laws in 2012, the time for debating new rules is fast running out. Soon they will be enacted. Industry concerns over unintended consequences and inconsistent application of the rules is reaching fever pitch. It falls to Roldán to address these.

Repercussions

The repercussions of any botch could be unpleasant. Concern over how the banking system will operate under a new regulatory system is already being felt in the market for bank equity and even more so for bank bonds, where access is intermittent for any but the largest banks, liquidity is drying up and uncertainties abound over the precise status of senior unsecured debt and how it will be bailed in to share losses with equity holders in the event of bank collapses. "To me it appears that senior bank debt is the new lower tier 2 and covered bonds are the new senior," says one investor.

Simple point

Roldán attempts to calm some of these fears. Basle III might far expand on Basle II by introducing new measures covering liquidity risk and leverage but it is essentially about making banks operate with more and better-quality capital. "This is good news for bondholders because you now have a higher buffer," he says.

But Roldán is also realistic enough to understand that the more regulators press for higher capital, the greater the incentives for banks to arbitrage the rules. In a feature within this issue (Banking: Monsters remain unleashed, Euromoney May 2011) Roldán talks about huge discrepancies between banks in applying very different risk-weighted asset calculations to similar portfolios of mortgages and other loans.

There is more than one way to arbitrage the system. Roldán addresses another risk: that of pushing more and more financial services activity into the shadow banking system. "One form of capital arbitrage may be to reduce low-margin, high risk-weighted asset activity. That might make banks prefer to provide shorter-dated finance to the economy rather than longer-term finance or close down other business lines that may not be profitable for the bank, albeit playing an important role in the economy. These unintended consequences should be an issue for us to watch." If banks won’t provide this kind of financing, it’s likely that someone else will.

The CFO of a large European bank points out: "The overhaul of regulation is all about containing and reducing the supply of financial market activity. It does nothing to address demand among borrowers and investors and common sense suggests that where there is a demand for something the market will supply it, even if that supply is provided from outside the regulated system."

If new capital rules on banks and insurance companies prevent them, other providers might step up. Will hedge funds become big providers of long-term loans for example to support project and other infrastructure investment in developed and developing markets?

The banking systems of Europe are deleveraging and new buyers are waiting in the wings to take up non-performing loans and also regular portfolios of unimpaired assets. PricewaterhouseCoopers now calculates that there are €1.3 trillion of loans held by European banks that have been identified as non-core, including performing as well as non-performing loans, that will run off or be sold over the next 10 years.

European overview
Estimated NPLs by country in €bln 2008 to 2010
200820092010 (i)
Germany142210225
UK107155175
Spain7593103
Italy425976
Ireland1588109
Greece122024
Russia (ii)11719
Poland61216
Ukraine268
Czech Rep345
Romania135
Hungary235
Turkey81111
Total416681781
(i) 2010 balance includes, in most cases, NPL information as at Q2 or Q3 2010 when year data was not available
(ii) Balance relates to overdue loans because no direct information on NPLs is available
Source: National central banks, PwC
Richard Thompson, partner at PricewaterhouseCoopers, says: "In the past markets have periodically sprung up around non-performing loans where non-bank buyers have stepped forward with specialist collection skills. I am not aware of any time before when there have also been so many distressed but still performing loans, and even fully performing non-core loans potentially available for sale."

PwC is in regular contact with 100 or so different hedge funds, private equity funds and other credit buyers now examining the loan market. "These are investors with different skill sets than we have seen in the past to maximize returns from performing portfolios," says Thompson. He adds: "I have a certain faith that where there is demand for a given type of financing, someone in the market will be willing to supply it. Are we going to see different providers of new loans in future, from the shadow banking system? That may well happen."

One European bank CFO agrees and adds: "Some of the portfolios we are selling are good quality and there is plenty of demand for them. The only reason we are selling is that we are no longer getting recognition for portfolio hedges but we are having to pay higher counterparty credit charges on those hedges."

It’s no longer economic for banks to do traditional business, especially as their cost of funding and requirement to match fund with longer-term liabilities increases. A specialist portfolio manager at a credit fund adds: "As it becomes more expensive for banks to raise capital either the cost of borrowing goes up substantially or it may make more sense for better-quality assets to be held outside the banking system."

Bankers predict that these run-offs and disposals are part of a painful process of dealing with the crisis just passed that also included absorbing more provisions and write-downs that will depress returns on equity and potentially pave the way for substantial consolidation in the banking system as its capacity reduces. Is that a desirable outcome? Roldán says: "Yes if it’s consolidation of a fragmented and weak part of the sector. In Spain it’s viewed as good that we are moving from 45 to 16 savings banks. But if we have more systemically important financial institutions in Europe than now in 10 years’ time, then that is not good and we need to structure incentives to forestall that."

"I am not aware of any time before when there have also been so many distressed but still performing loans, and even fully performing non-core loans potentially available for sale"
 
Richard Thompson, PricewaterhouseCoopers

Meanwhile, it’s worth recalling the key role of unregulated mortgage originators in accruing the badly underwritten sub-prime housing loans that precipitated the financial system crisis in the US. Money-market mutual funds, bank-like but not regulated like banks, were central to the panic that spread at the end of 2008 and start of 2009. Roldán is keenly aware of the potential for the unregulated system to grow. "If you are a hedge fund or other type of fund extending credit and engaging in maturity transformation of short-term liabilities into long-term loans, then you are a bank, but one without access to central banks and that’s potentially quite dangerous." He adds: "The good news is that the Financial Stability Board will be conducting more monitoring of risk and vulnerabilities within the financial system as a whole." He wants the banks to help this process by blowing the whistle. "I am afraid that dialogue with the banking industry has been a disaster over the past two years as banks have told us they think Basle III will end the world and we’ve replied that we think it will save the world. In future, we need the international bank with operations in many countries to report what it sees where the playing field is unlevel and risks are emerging."

Roldán admits to Euromoney: "We lack a lot of information on the shadow banking and financial system and it may be difficult to disentangle the interconnectedness to the regulated system." Is it a bad thing that it looks likely to grow as a result of Basle III rules and by the deleveraging those rules are now encouraging? Roldán says: "If credit risk ends up with a final investor that can absorb potential losses, then that is fine. But it may be worse if it goes from banks to other financial intermediaries running a maturity mismatch and with a systemic relevance to other financial institutions. The problem is that we don’t know."

It would seem a good idea for regulators to try to find out.