It was exactly five years ago to the day when the European Central Bank took over the supervisory duties of the major and systemically important banks in the eurozone. Following the financial crisis that erupted in 2008, EU politicians decided that to make a similar crisis less likely in future, Europe needed to embark on a Banking Union built of three pillars: the Single Supervisory Mechanism, the Single Resolution Mechanism and the European Deposit Insurance Scheme.
The success of this ambitious project can be judged by measuring changes implemented so far against the stated objectives of politicians when they mandated the creation of the Banking Union.
The Supervisory Mechanism has undoubtedly brought about significant changes in the way that European banks define their business models and their governance. I remember the pre-crisis time when being made in charge of risk management in a bank used to be the death knell to one’s career progression. Things have certainly changed in the last five years!
One objective of the ECB was to cut the proverbial umbilical cord between banks and governments. This link in some southern European countries like Spain, Italy and Portugal was one of the leading causes of the financial crisis. Banks not only gorged on the sovereign debt of the spendthrift countries in which they operated but also built unholy alliances with politicians who cared little about the long-term sustainability of banks’ business models.
What should be worrying policymakers and make them miss hours of sleep is the phenomenon of shifting enterprise risk in an easy money scenario to retail investors
One word that has made its mark in banking literature over the past five years is ‘de-risking’. This phenomenon comes in different shapes and sizes. It is also not such a positive development in the broader picture of economic management.
The International Monetary Fund in its latest Global Financial Stability Report puts a spotlight on the most likely causes of the next financial crisis. This report confirms that while banking may be safer today, other areas in the financial sector are showing an unsustainable risk appetite in the present scenario of low-interest rates.
The IMF warns that persistently low-interest rates are encouraging investors to take dangerous risks in a quest to maintain financial returns. While this report focuses mainly on current practices by insurers, asset managers and pension funds that are diluting the quality of their assets by buying riskier bonds, the plight of retail investors in the capital market is even more worrying.
At the local level, we are seeing banks being more cautious about lending for projects that are perceived to have a higher risk profile than they are prepared to accept. Entrepreneurs do not seem to be unduly worried by the banks’ more prudent approach. They find that the local capital market is very accommodating. Both the regulated and the Prospects markets managed by the Stock Exchange are giving entrepreneurs the chance to shift the risk of their projects on to retail investors many of whom do not understand how to price risk.
A five per cent coupon offered by a junk bond issuer is sufficient to lure the uninformed investors into risking their financial health after signing legal documents that are too technical for an ordinary person to understand. A stock exchange should never be entrusted to act as regulator, supervisor and promoter of the capital market.
Entrepreneurs involved in high-risk projects are experts in transferring risks to their creditors. Banks are now unwilling to play this game. So the risks are in many cases being transferred to retail investors who gobble up any bond that offers a return higher than that of bank deposits or sovereign bonds.
Policymakers need to look at the bigger picture if they are to reduce the risk of another financial crisis. The IMF makes a very sobering recommendation when it says that ‘policymakers should urgently seek to extend banking regulations introduced after the financial crisis to other parts of the financial sectors such as insurers, asset managers and pension funds’.
In the local context, I would recommend that the local capital market should be better regulated to protect financial stability and protect retail investors.
The Banking Union is still very much work-in-progress. The Single Resolution Mechanism contains some major flaws as decisions to wind down an insolvent bank are taken centrally, but the implementation of such decisions are entrusted to individual member states. National politics will always clash with EU politics.
However, what should be worrying policymakers and make them miss hours of sleep is the phenomenon of shifting enterprise risk in an easy money scenario to retail investors.