The last 10 years saw more attempts to reform financial regulation than in the previous three decades. Following the 2008 financial crisis, the EU set ambitious targets for banking reform enshrined in the Banking Union project. It is now inevitable that the next decade will see even more change as the COVID economic crisis exposed some significant weaknesses in current regulation.
The European Central Bank, the European Banking Authority and the Bank of International Settlement have rightly eased the pressures on banks in the last few months by extending deadlines for significant reforms envisaged in banking regulation, especially Basel IV. The EBA has postponed its 2020 EU-wide stress testing of banks to 2021. This is understandable as this year most banks had to deal with a real-life stress test that stretched their operational resources in a way never experienced before.
The Banking Union project remains work in progress. The Single Supervisory Mechanism is the only pillar of reform that is practically complete. It has upgraded the standards of supervision and removed it from the control of national authorities that are often prone to undue political influence.
National interests still prevent progress in the other two pillars. The Single Resolution Mechanism is theoretically in place but its implementation remains mired with unconvincing political manoeuvring in the different member states. The Single Deposit Guarantee framework is no more than the wishful thinking of euro-crats who know that national interests have always prevailed in the EU decision-making process.
Perhaps the most difficult challenge financial regulators need to address is ensuring the low-interest rate scenario will not make banks’ business models unsustainable
The tone from the top of the ECB in the last decade has been for risk mitigation by banks who are repeatedly urged to review their business model. The pandemic has shown that when financial stability becomes a priority for governments and regulators, prudential regulation is put in a deep freeze.
The ECB has committed itself to buy distressed sovereign and corporate debt to prevent a collapse of the capital markets. Governments have been guaranteeing the debt of enterprises that risk going out of business because of the present economic downturn. Moral hazard seems not to worry regulators all that much in this time of crisis.
Future regulation will need to address the pro-cyclical elements of recent banking regulation. At a time of economic distress, banks are urged to increase their capital and provide more aggressively for doubtful debts. The mantra that taxpayers will no longer be expected to bail out imprudent banks has become unfashionable. Governments are now having to use taxpayers’ money to bail out distressed businesses.
Financial services regulation now needs to address the phenomenon of risk-taking being shifted from banks to shadow banks and the capital markets. These alternative credit providers seem not to have any inhibitions for selling corporate debt to investors who may lack the skills to evaluate and price risk. If regulation does not tighten on non-bank credit providers, we may soon experience another debt crisis.
Regulation on the use of information and communication technology is still not evolved enough. The trend to move to digital delivery channels in financial services will accelerate as a result of the operational challenges that financial institutions had to face before and during the pandemic.
Cybercrime, operational resilience and need for substantial investment in ITC hardware, software and training will be on the board agenda of most financial institutions and their regulators. Small- and medium-sized banks face a daunting task as the investment needed to have a comprehensive and effective e-banking delivery channel are substantial. Partnering with fintech companies may well be the best survival strategy for such banks.
European banking regulators have often complained that until the European banking system becomes less fragmented, it will never reach the profitability levels of the US system. Once again, national political priorities will delay, if not prevent, more consolidation in the industry.
National politicians will always find solid arguments to avoid their local banking champions from being taken over by foreign banks.
Perhaps the most difficult challenge that financial regulators need to address is that of ensuring that the low-interest rate scenario that is expected to persist for a few more years will not make banks’ business models unsustainable. Banks need to raise capital to meet regulatory expectations and to invest in the digitalisation of their services. At the same time, they have been advised not to pay dividends. This is the perfect formula to scare investors in banking stocks.
The challenges facing regulators will be just as daunting as those of the regulated.