The greatest risk is risking nothing at all
The impact of regulatory reform is disabling, rather than enabling, the flow of credit in the global financial system. This is one of Allen & Overy’s conclusions in their report, “The Future of Credit”. In it, the international law firm highlights the confusion regulatory burden is creating.
New regulation can have unintended consequences, which Allen & Overy lawyers call “staggering”. This is far from being an exaggeration. The Dodd–Frank Wall Street Reform and Consumer Protection Act in the US alone run 30,000 pages, quite an impressive number, and one which would be doubled in Europe’s rulebook. Consequently, Europe’s top 350 banks will need to hire more than 70,000 new compliance experts, according to Allen & Overy.
Henri Wagner is the managing partner of Allen & Overy Luxembourg and the partner in charge of the banking and capital markets department. He says that a balance has to be struck between the need to regulate the financial sector and making sure that the economy works on the provision of credit flows. But this is easier said than done. “The governments of Europe and the US have taken a very strong stance on what caused the crisis and the need to strengthen financial regulation. The response of the various governments has been very strong and we have seen an increase in financial sector regulation like never before”.
Henri Wagner adds that the governments and the regulators are the guardians of our financial stability and therefore need to take a relatively strong position. At the same time, he is convinced that regulation only makes sense if it is sensible and focused on the needs of the real economy.
Because of the increasing regulation, it has become more difficult for banks to provide credit to the real economy. “Solvency ratios will be increased as well as leverage ratios; there will also be need for liquidity buffers. This means that possibilities for banks will diminish; balance sheets will shrink, meaning that banks will have more difficulty granting credit”.
The deliberate and systematic tightening of regulation around the world is shrinking the size and scope of banking activity. Henri Wagner said this, quoting Anshuman Jain, Co-CEO of Deutsche Bank, who said recently that it is possible that in the future there will only be ten global banks in the world simply because of the pressure on banks’ balance sheets. “So you will have large players with strong balance sheets who can continue a global universal banking business; all the medium sized players will disappear; and the smaller banks will be niche players”, Henri Wagner completes.
It is obvious that banks will not disappear, but their relative importance will be diminished. The Allen & Overy report predicts that opportunities for alternative players will open, but very gradually. Henri Wagner currently lists players that come into the credit provision market. “At this stage, it is mainly large private equity houses or asset managers sitting on a pile of cash, which they are prepared to invest in the real economy. Secondly, there are the traditional hedge funds, which also have significant financial resources. Another sector is the insurance sector and we have been approached by a number of insurance companies to look into their regulatory questions. They will certainly have a role to play in the context of shadow banking and credit provision in the system”.
The market now faces years of regulatory wrangling before local regulators implement proposals and directives.For Luxembourg it is important to position itself to create a favourable environment for these new players; this implies creating an environment which provides legal certainty and enables alternative players to grant credit to the real economy. Henri Wagner underlines that the role of the Luxembourg regulator is essential.
“Obviously, these new players – because of their size, their business model and the way they operate – do not wish to be regulated under the Banking Act of 1993, which says that if you grant credit to the public, you need a license, because there would be no added value for them. The regulator sits between two stools: on the one hand he has to make sure that a crisis like this does not repeat itself while on the other hand giving these new players the ability to make credit available”.
If the regulator, however, were to become too stringent, this would be harmful for Luxembourg because these new players would turn towards another jurisdictions, be they Ireland or the Netherlands, countries with comparable frameworks.
All in all, it is a balancing act between the need for regulation and the need to inject money into the system to get various economies back on the path to growth. On that subject, Henri Wagner says that there has been a sort of overreaction. “The Financial Stability Board especially has taken a relatively strong view, in the sense that they believe that non-banking credit provision needs to be subject to prudential regulation comparable to that of banks. I think that this analysis is wrong: it has to be more refined, because some of these new entrants do not create a risk in the financial system in the same way banks do”, he concludes.
In the end, the dilemma that policy makers must face is to choose between making the financial system so safe that it creates paralysis or accepting that a functional financial system carries a degree of risk and should be promoted as such. CW