The post-financial crisis macroprudential regulatory policy and the future of banking. Back to a public utility?
An exploratory study on the 2014 break-up of Portugal’s failed lender Banco Espírito Santo
Master's Thesis 2016 33 Pages
A BANKING UTILITY
HISTORY OF BANKING
MACROPRUDENTIAL TOOLS & CAPITAL ADEQUACY
THE GLOBAL FINANCIAL CRISIS
BIS, Basel Committee and the Accords
BANCO ESPÍRITO SANTO
“BEFORE AND AFTER”
BACK TO THE DRAWING BOARD?
A BANKING UTILITY
More interested in the macroeconomic aspect of regulation rather than its legal underpinnings, I decided to investigate a tremendously pertinent topic on which there does not seem to be a lot of literature, with the aim of critically evaluating the impact of increasingly stringent prudential regulation on the banking sector.
The concept of “banking as a public utility” only makes sense when contemplating the traditional commercial and retail banking services for the public, such as operating deposit accounts, executing payment services or providing loans. In the early stages of banking, when interest charged on loans and deposits was merely symbolic - largely due to the religious restrictions on usury -, banking practices were seen as serving a low-return public utility.
In this research paper, I addressed the question of whether large banks, forced to reduce leverage and strengthen liquidity in light of rigorous capital adequacy requirements, will restrict their business in the near future by getting rid of non-core activities, only to permanently turn to low-risk and limited profitability basic banking activities, serving a public role similar to that of public utilities such as gas, water or electric companies.
As a quantitative analysis would be inappropriate for this academic discipline, in order to reach an empirical conclusion, I employed historical and qualitative research methods to examine the regulatory reform that followed the 2007-2008 global financial crisis, with a technical focus on Basel III, followed by a practical case study with a comparative analysis of the business model of Banco Espírito Santo - the Portuguese banking group giant that was very active on the money markets and went bankrupt in the summer of 2014 - and of Novo Banco - the "good bank" salvaged from the ruins of BES and everything that its predecessor was not: a deleveraged institution dedicated to taking deposits and lending to companies, as well as other core consumer banking activities; the hazardous ‘before’ and the possibly safer ‘after’.
I have concluded that despite upcoming significant changes, banking will not, in the short to medium term, entirely transition into public utilities, as dividends payouts have become largely unaffected thus far and there are alternatives to shrinking. Whilst contemplating the future of universal banking, I came across the issue of a possible restoration of a Glass-Steagall regulatory barrier, where commercial and investment banks would either be separated or coexist with the ringfencing of one or the other. I also addressed the topic of boutique banks and the recent technology-enabled “challenger banks”, which will play an important role in the future retail banking sector.
HISTORY OF BANKING
The world’s oldest banking institution can be traced all the way back to 1472 in the Italian region of Tuscany. Bankers of the currently troubled lender Monte dei Paschi di Siena, were said to have sat on long benches, in the open air, to fill out their account book, and the Italian word for bench, ‘banco’, is said to have given rise to the English word ‘bank’.
Traditional banking activities, however, began a lot earlier, with farmers from the early civilizations taking out loans of grain and other commodities in return for security. Moreover, there are records of temples being used as a space to safeguard deposits of gold in Ancient Greece, Rome and Egypt.
The first cross-border banking institution appears to have been that run by the Knights Templar, a religious order founded in 1118 that helped to fund crusades and exchange money, as well as acting effectively as bankers to the Pope.
Banking would not really flourish in Europe until the 12th century in northern Italy, where some of the most powerful families from the wealthy cities of Florence, Venice and Genoa had a go at establishing banking dynasties, among which lied the famous Medici bank. Not long after, the same happened in Germany with the Fuggers, the Welsers and the Hochstetters, prominent families from the city of Augsburg, “easily accessible from northern Italy”.
In London, goldsmiths performed many of the functions now attributed to banking. They provided custody of valuable items, currency exchange services and accepted gold in exchange for a receipt, as well as written instructions (where the banknote derived from) to pay back, even to third parties.
Later, following the rise of new banking functions in the 17th century, from cheques to overdrafts, banking practices were regulated and central banks were born, starting with the Bank of Amsterdam in 1609, followed by the Bank of England in 1694.
The Dutch East India Company, a giant in international sea trade existing from 1600 to 1874, was the first corporation to issue securities on a stock exchange, in the Amsterdam Stock Exchange, now known as Euronext Amsterdam.
To complement the evolution of banking, cash dispensing machines and electronic payment systems were created in the 20th century. Later came electronic trading and innovation in capital markets products, enjoying the wave of deregulation in the United States economy in the 1980s. After the Glass-Steagall Act (enforcing a division between commercial and investment banking) was repealed by the US Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, universal banks as we know them today, offering a wide array of financial services, started to propagate, from JPMorgan Chase and Bank of America to Deutsche Bank and Barclays.
A free market economy is an idealized form of a non-regulated market where no restrictions are imposed on buyers and sellers, who “determine what products are produced, how, when and where they are made, to whom they are offered, and at what price—all based on supply and demand”. In practice, the theory of a free market is utopic, since regulation – through the three powers of its agencies: to legislate, police and enforce - is essential to prevent abusive practices and maintain financial stability by ensuring public confidence in the integrity of markets. Regulation, however, also has its downsides: It can be extremely costly for players in the financial industry to implement effective compliance systems and to abide by increasingly complex requirements, which sometimes has the undesired consequence of making financial institutions turn towards riskier, unregulated activities, as proven by the recent growth in peer-to-peer lending platforms (a popular segment of the shadow banking industry), raising other threats, such as cyber risk, one of the five largest threats to the UK’s financial stability according to the Bank of England’s 2015 Financial Stability Report.
The distinction between conduct and prudential supervision is especially clear in the United Kingdom “Twin Peaks” regulatory structure, where, below the Bank of England, we can find the Prudential Regulation Authority (PRA), a subsidiary, and the Financial Conduct Authority (FCA), an independent body corporate.
illustration not visible in this excerpt
Source: Practical Law 
The overarching aim of conduct regulation is consumer protection from harmful actions caused by negative behaviour from financial institutions, also ensuring market integrity and transparency by preventing financial crime. On the other hand, prudential supervision is balance-sheet focused in that it promotes the safety and soundness of financial institutions with a focus on risk, asset quality, capital and liquidity. Within prudential regulation, preventive tools involve those techniques which are designed to avoid crises by reducing the risks facing banks, including monitoring the management of banks capital solvency and liquidity standards. Protective techniques, in turn, provide support once a crisis threatens, for example in the form of a “lender of last resort”. There is yet another crucial distinction to be made within prudential regulation: While macroprudential regulation offers a bird’s-eye view of the financial system as a whole, aimed to mitigate systemic risk by “identifying potential threats to stability arising from financial market developments ”, microprudential regulation is more firm-specific in that it seeks to prevent the failure of individual financial institutions in order to protect depositors and consumers. This distinction essentially stems from both of these theories’ approach towards risk. While it is taken as ‘exogenous’ under the microprudential perspective, in the sense of assuming that the events leading up to a financial crisis do not stem from the behaviour of the financial system, adopting a macroprudential approach requires that the interlinkages within the financial system and between it and the real economy be taken into account. Even so, it is natural for macroprudential supervision to spill over microprudential concerns and also for macro tasks (such as the gathering of data and information and analysis of banks reports) to overlap with micro tasks. illustration not visible in this excerpt Source: Bank for International Settlements 
Banking is undoubtedly one of the most regulated industries in the world, and the rules on bank capital are some of the most prominent aspects of such regulation, stemming from the importance of banks as financial intermediaries and providers of liquidity to the economy. In this dissertation, I will be focusing on the macroprudential regulatory reform that followed the global financial crisis of 2007-2008 and predicting the impact it will have on the banking sector.
MACROPRUDENTIAL TOOLS & CAPITAL ADEQUACY
Macroprudential instruments used by central banks to prevent or mitigate systemic risk do not replace the existing regulation of banks already carried out by regulatory bodies, but are mere supplementary mechanisms, used as temporary restrictions to increase the resilience of the banking system during volatile periods of high credit risk. Macroprudential policy essentially involves three categories of instruments: those constructed to have an impact on the pro-cyclicality of the financial system (eg. countercyclical capital buffers, applied during periods of very strong credit growth to help ensure the banking system has an “additional cushion against losses or sharp increases in risk-weighted assets that may be associated with an economic downturn or significant financial system distress” ) or on the contribution of a financial institution to systemic risk (eg. systemically important financial institution surcharges), prudential instruments to address a build-up of systemic risk in specific segments of the market (eg. limits on loan-to-value ratios, risk assessments that lenders examine before approving mortgages ) and tools to address systemic liquidity concerns (eg. the liquidity ratio, a reserve requirement aiming to reduce reliance on short-term debt financing).
The main tool to focus on in this paper, however, is the capital adequacy requirement, also known as regulatory capital, which reflects the minimum capital amount that banks must hold relative to their assets, and is expressed by the Capital Adequacy Ratio. A bank’s capital serves as a buffer from which any losses are taken, and provides a reserve from which bank depositors and creditors may ultimately be repaid when losses can no longer be absorbed in case of a bank failure. The fundamental question to address, however, is what overall level of bank capital is optimal. In theory, as the FSA’s Turner Review (2009) concludes, this should be based on a trade-off between:
(a) the economic benefits of higher bank capital in the reduced probability of bank defaults and financial instability ;
(b) the economic costs of higher capital, which arise because banks facing higher capital requirements will need to reflect that with an increase in the cost of provision of bank loans – meaning consumers will see less available credit and at much higher prices -, possibly resulting in a deleveraging but shrinking economy, with “more bankruptcies, lay-offs and fewer jobs ”.
THE GLOBAL FINANCIAL CRISIS
In mid-September 2008, the near collapse of AIG, the world’s largest insurance company, and Lehman Brothers filing for the largest ever bankruptcy in the United States, triggered an unprecedented global recession.
Since 1980s “Reaganomics ”, financial markets in the US were highly deregulated, making way for innovative financial engineering in the field of OTC derivatives. What is more, due to the high leverage ratio allowed for financial institutions and cheap credit deriving from low interest rates, there were no constraints on banks heavily increasing their borrowing.
Throughout the early 2000s, US property prices rose much faster than they had in the previous decade, an increase fuelled for the most part by mortgage lending practices, namely the relaxing of standards when it came to evaluating the creditworthiness of applicants. Many average Americans were granted loans to buy houses through mortgage brokers, who got commissions for their deals. The mortgage lenders, in turn, sold these to investment banks, who bundled them together with other loans to form a structured product called collateralized debt obligation (CDO), selling these off to investors all over the world. As investors turned away from low-interest rate treasury bills and demand for these mortgage-backed securities increased, predatory lenders further lowered their standards, allowing “subprime” borrowers (low income buyers with poor credit history) to qualify for home loans, which were then sold off to investment banks again, who sent them back to investors as CDOs, in a vicious chain of securitization.
Meanwhile, credit rating agencies who were paid to evaluate the CDOs by the very own financial institutions who designed them, granted a triple-A rating - the safest investment rating tier - to a large chunks of the CDO tranches which were highly dependent on the performance of the subprime loans. Traders, in turn, relied on the ‘AAA’ label “without developing their own models or carefully examining the assumptions on which the models of the rating agencies were based”.
As the granting of easy credit continued and subprime lending increased, housing prices sky-rocketed, creating the largest property bubble in history.
At the same time, AIG Europe had been selling credit protection on CDOs to investors in the form of credit default swaps, many of which originated from the subprime loans. When borrowers defaulted, AIG lacked capital to honour its financial commitments, leading to a liquidity crisis which would result in the largest government bailout of a private company in US history, costing tax payers over $150bn.
When mortgage holders started to default and foreclosures increased, real estate prices finally started to fall, causing lenders to fail and leaving banks and investors with several worthless mortgage-backed securities on their hands.
After record losses and rumours to be insolvent, Bear Stearns was the first influential financial firm to collapse, being taken over by JPMorgan Chase with the aid of the Federal Reserve, who feared systemic risk. The same happened with Washington Mutual, after it was placed under the custody of the Federal Deposit Insurance Corporation. Not much later, troubled lender Merrill Lynch was acquired by Bank of America and the US government seized control of Freddie Mac and Fannie Mae, agencies that held and guaranteed approximately 50% of all US mortgage loans. More government bailouts and emergency loans prevented the global financial system from collapsing, but not without leaving a deadly credit crunch behind, which led the world economy into the worst depression since the stock market crash of 1929. In a hugely globalised world of interlinked economies, contagion was inevitable: Three major Icelandic banks were nationalised, Northern Rock was taken into public ownership and the Royal Bank of Scotland required a £45bn bailout from the UK government. Global interest rates plummeted, international trade and exports fell and unemployment rose on a global scale.
Among other equally significant causes, it seems evident that regulators had failed. Quoting the 2011 Financial Crisis Inquiry Report, “it is clear the sentries were not at their post, in large part, because of the widely accepted belief in the self-correcting nature of the markets and in the ability of the financial firms to effectively police themselves.”
After the Larosière Report (2009) provided an explanation as to how the risk accumulated in the financial system went undetected for so many years to the narrow focus from a supervisory perspective on individual financial institutions, which did not allow for a full picture to be gained of the risks building up across or between institutions, the EU Regulation No 1092/2010 of the European Parliament and of the Council of 24 November 2010 established the European Systemic Risk Board, tasked with “establishing macroprudential frameworks and ensuring effective coordination and internalization of cross-border spillovers”. In a clear shift of focus to containing the risks originating in the financial system, policymakers and regulators began to look for anti-bubble tools, in order to “reduce the severity and frequency of excessive credit growth ” in the economy, but also to effective crisis management techniques, including recovery and resolution measures aimed at reducing both the probability and impact of a bank failure.
Next came the Solvency II Directive issued by the European Union in 2009, aiming to ensure that insurers and reinsurers could meet their obligations to policy holders and beneficiaries over the following 12 months of entering into a contract with a 99.5% probability, which limits the chance of falling into financial ruin to less than once in 200 cases.
In 2010, the Obama administration passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which aimed to prevent the reoccurrences of the 2008 global recession by tackling the “soft spots” of the US economy. Dodd-Frank established new United States federal government agencies such as the Financial Stability Oversight Council, which monitors the performance of companies deemed “too big to fail” in order to prevent a widespread economic collapse. Similarly, the new Federal Insurance Office identifies and monitors insurance companies that may pose a systemic risk. The new Consumer Financial Protection Bureau is tasked with preventing predatory mortgage lending and reducing incentives for mortgage brokers to drive home buyers into more expensive loans. The Volcker Rule (2013), another key component of Dodd-Frank, prohibits banks from engaging in proprietary trading, restricts the way they can invest in funds and regulates derivatives trading. Lastly, the goal of the new Securities and Exchange Commission’s (SEC) Office of Credit Ratings is to monitor the precision of ratings provided by the agencies evaluating the financial strength of businesses and governments.
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 The Reagan administration’s (1981-89) economic policy.
 “The derivatives markets, with all the sophistication they involve, do not constitute an advance in capitalist money markets. Rather they demonstrate a deepening in the underlying crisis. Derivative instruments carry with them increased volatility and as such have direct effects on the national economy. They also carry business risks for the organisations which become involved in them because they are speculative as well as controlling risk”. Source: Hudson, Alaistar. The Law on Financial Derivatives, p.228, Sweet & Maxwell, 1996.
 A form of structured finance consisting in the pooling of assets to form a tradeable security.
 These would later be downgraded to “junk” status.
 Hull, John. “The Credit Crunch of 2007: What went wrong? Why? What lessons can be learned?”, p.2, Joseph L. Rotman School of Management, University of Toronto, 2009.
 A financial derivative in which the seller agrees to compensate the buyer should a third party default on a loan.
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