The ECB pushes back on bank “deregulation”

The topic of banking “deregulation” has come back to the fore this year, mainly fuelled by initiatives from the US authorities. The topic never seems far from the headlines, with banks continuing to push their own agenda and arguing that higher capital requirements stifle international competition and constrain lending to the real economy. As a result, banks argue that lowering capital requirements could unleash lending growth and put European banks on equal footing with international peers (especially in the US, where we have seen a deregulation bias).

Last week, Claudia Buch, chair of the Supervisory Board of the European Central Bank (ECB), made a speech in Frankfurt where she has pushed back against the banks’ narrative on restricted lending and gave us further insight into the regulatory perspective on some of the common complaints we have seen from the sector.

First, Buch highlighted the growing prominence of what she described as “watchers of regulation”. She noted that banks are very vocal in arguing and pushing their own agenda, which implies that they can skew the narrative and outcomes in their favour. Banking sector stability has an impact on many other players in the market such as savers, companies and taxpayers, she argued. As a result, Buch wants to see broader participation of policymakers, the public, academics, analysts, and journalists, all of which have a vested interest in macroeconomic stability, to bring more balance to a debate she believes is largely led by the banks.

Second, Buch pushed back on the assertion that higher capital requirements reduce lending to the economy. She noted that capital requirements need to be viewed in the context of the cyclical environment, as opposed to being viewed as point-in-time: “…banks entering a downturn in a stronger capital position tend to perform better and maintain lending more effectively than banks starting in a weaker capital position. Weakly-capitalised banks are more likely to restrict credit when losses materialise.” In addition, Buch argued there is tangible evidence that reduced capital requirements do not necessarily generate additional lending. Specifically, she indicates that the so-called SME- and infrastructure-supportive factors (regulatory overlays that reduce the amount of capital held against these exposures) did not stimulate lending to SMEs vs. large corporates.

On the cyclical behaviour of bank lending, we would indeed point out that this is natural behaviour for any lender. In a downturn scenario, where a bank may hold a lower buffer of capital above minimum requirements, the first reaction is typically to curtail lending activity. If done by a single lender, this can be more than manageable at the macro level, but if it occurs across several lenders simultaneously, it leads to natural contraction of credit supply to the economy. Higher capital buffers over the minimum requirements do not guarantee that lending will be maintained during a downturn, but they do at least minimise the risk that banks enter a downcycle with thin capital buffers, which would contribute to the problem of credit contraction.

Third, Buch focused on the linkage between banks’ performance and capital requirements: “…recent work shows that, broadly speaking, capital requirements for banks are comparable internationally and not a relevant driver of performance. Rather, banks’ ability to compete successfully is driven by structural factors, such as the adoption of technology and the ability to achieve scale and operating efficiency.”

We would certainly echo this view. Indeed, we do see divergence in performance between banks that have embraced new technologies vs. those that rely on legacy systems, for example banks that stick to the branch network and the dedicated customers vs. those that are digitising their deposit-gathering proposition. In the current environment of slower lending growth, margin compression, and higher costs – where the sector is still averaging a double-digit return on equity – we have in some cases observed the benefits of the inorganic growth and greater scale that can be achieved via mergers and acquisitions.

Having said that, some bank performance metrics (especially when measured by return on equity) are very closely linked to their amount of capital. Specifically, if a bank was to double the amount of capital it needs to hold, it would halve its return on equity and therefore become less attractive to potential equity investors (we do not think the cost of capital would halve in such a scenario).

Overall, we consider all the above as a valuable contribution to the topic of banking (de)regulation. We continue to view the stronger regulatory backdrop post-2008 as the key driver behind the improved fundamentals underpinning the strong profitability European banks are currently experiencing. As such, we believe a material relaxation of the rules would likely increase banks’ overall cost of capital and undo the significant work that has been done to put the sector in a good place ahead of the next downturn.