The European Commission’s financial reform programme has made the EU financial services sector fundamentally more resilient, reducing the likelihood of bank failure and containing its effects should this occur. But the right balance needs to be found so regulation does not prevent the financial sector from carrying out its basic economic functions and supporting future economic growth.

The Commission’s recent consultation on the impacts of capital requirements on the European economy kicks-off the Capital requirements regulation and directive (CRD4/CRR) review process and represents the ideal opportunity to determine where that balance should sit.

Untangling the effects of multiple regulatory change

Unfortunately, however, the Commission’s consultation does not take into account the significant impact of the measures other than capital requirements that are also part of the CRD4/CRR – notably liquidity and leverage requirements. Moreover, its scope does not extend to the Bank Recovery and Resolution Directive – a new prudential framework that goes hand in hand with the CRDIV, providing authorities with the toolkit to manage recovery and resolution, ensuring the continuity of a bank’s critical functions and restoration of viable parts.

That said, another consultation exercise – the recently launched cumulative impact assessment, issued in conjunction with the Commission’s Capital Markets Union (CMU) action plan – should help in understanding the broader implications of EU prudential regulation within the overall financial reform package.

But looking at current legislation is only part of the picture. Beyond the EU, there are several initiatives underway at international level that are likely to further increase capital requirements and significantly reduce the prudential framework’s level of risk sensitivity. Some are already calling this programme of change “Basel 4”.

It is crucial for the Commission to consider how these future developments may impact European growth. Financing of growth requires daily decisions to be made on risk, so there is a concern that a lack of risk sensitivity in the capital framework will lead to a mispricing of risk, creating a misallocation of capital across the economy, less diversification across firms’ portfolios, and potentially increasing risk to the financial system as a whole. Moreover, the uncertainty banks face regarding calibration of the various requirements, the sometimes contradictory interactions between the requirements, and the prospect of yet more regulation, complicates their decisions on how to best allocate capital. Uncertainty thus ends up affecting the range and pricing of the products and services they can offer to their customers.

When examining the prudential framework and the impact it has on the economy, the Commission’s analysis and review must therefore be comprehensive and forward-looking.

Making sure the end-user doesn’t lose out

Banks have responded to previous regulatory reform by taking multiple restructuring actions, both organisationally and in their product offering. The regulatory changes driving these responses may represent an over-correction, beyond what could be considered as “necessary deleveraging”. Indeed, the decrease in lending to corporates and the structural and comparably small share of market-based financing in Europe are signs that bank customers are being presented ever-decreasing choice. This will potentially be worsened by the current draft bank structural reform proposal for the separation of banks’ trading activities

While there may not yet be an apparent impact on prices to customers, the extensive cost cutting and activity reduction undertaken by banks over the past years means that banks may have been able to shield their core customers from much of the impact of regulation. However, this can only be a finite exercise, particularly given persistent low returns and the increasing pressure from shareholders for higher returns which are driving significant organizational and managerial changes at several leading banks. Regulators too cannot be indifferent to low industry returns. Banking profitability plays an important role in contributing to financial stability as retained earnings are the main source of additional capital needed to meet higher capital requirements.

There is also evidence that low returns on capital have forced many banks to exit or reduce market-making activities. This implies that they are now being more selective in offering their balance sheet capacity, with market liquidity in both primary and secondary markets being affected. There are concerns that market liquidity could be further affected when interest rates rise. End-users will ultimately lose out and face a less diversified and more costly capital markets offering.

Getting the balance right

To be clear, the industry fully supports much of the post crisis regulatory repair programme and its key objectives. However, with the development of the CMU in the EU being one of the key priorities for policymakers, it is essential that the Commission examines how the prudential framework, including prospective further changes emanating from Basel, affects banks’ ability to provide market liquidity. Moreover, even once economic growth returns and monetary policy normalises, restrictive regulation means that the industry may very well not be in a position to support this growth.

The Commission now has a once-in-a-generation opportunity to put in place a prudential regulatory framework to support growth and develop European capital markets.

This framework must involve finding the appropriate trade-off between the benefits of financial stability and a banking sector that is able to provide credit to the economy. But this balance should not be jeopardised by unnecessary regulatory layering.