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The regulatory cost paradox

  • Financial Analyst
  • Blog post submitted on 22nd January 2020
06744 CC Trader Talk V2

It is no secret that the banking industry is one of the most heavily regulated industries in the world. The reasons for the incessant march towards further tighter regulatory controls dates back to the aftermath of the financial crises experienced in 2008. Picking on one consequence of the global financial crises during that period, government and supranational bodies were ultimately forced into huge bailouts of large banks in an attempt to avoid complete Armageddon.

During the bailout processes, which constituted using taxpayer money to sure up bank’s capital and reserves due to extreme reported losses, senior bondholders were left generally unscathed since they ranked equal to depositors in the capital structure of the bank. During the post-mortem of the financial crises, regulators and stakeholders alike felt that this was an unfair outcome, and that bondholders ought to assume their fair share of risk as suppliers of capital. A regulatory overhaul was subsequently set into motion.

Fast forward to today, and we are now facing a banking industry that is burdened with many levels of controls and safeguards to ensure that a repeat of 2008 does not materialise. Among these are minimum capital requirements, which get increasingly onerous the more systemically important the financial institution is to the local and/or world economy, risk management programmes and reporting requirements.

The Financial Stability Board created the TLAC ratio (Total Loss-Absorbing Capacity), which defines the capacity of a bank to absorb financial losses in the event of a crisis. These regulations are largely geared towards the global/local systemically important banks, comprising the requirement of capital and similar instruments which would represent 16% of their total risk-weighted assets (RWA), i.e. much higher than the level stipulated in Basel III (8%). In 2022 this capital buffer will be raised to 18%.

Similarly, the ECB is in the process of finalising a key piece of similar regulation called the Minimum Requirement for Own Funds and Eligible Liabilities (MREL) that specifically deals with the previously mentioned moral hazard. These new pieces of regulation are leading to a new class of capital in the complex web of a bank’s capital structure, called Senior Loss Absorbing Instruments (SLAs) equivalent to Tier 3 non-preferred senior debt. These will slot in above Tier 2 subordinated debt, and new issues in these types of bonds are expected to be prevalent in the next few years.

Banks, to varying degrees, are being essentially forced into holding bonds that are capital contingent, meaning that in the event that the bank faces solvency issues, the related coupon can be temporarily turned off, the bonds immediately converted into equity or cancelled altogether without triggering further default events that would jeopardise the local/world economy. The most stringent of these bond-equity hybrid instruments are known as “Additional Tier 1” capital (AT1). These form part of the capital base of the bank, and are a key component of the frequently quoted Tier 1 Ratio, a measure of capital at risk.

Intuitively, these instruments carry a decisive element of risk, and are often restricted to professional investors. A quick overview of the AT1 market purports an average coupon in excess of 6 percent for this class of instrument across European banks.

Placing this in a local context, Bank of Valletta plc is currently engaged in the process of issuing an AT1 debt instrument to the tune of €150 million; a process it was expected to complete by end of 2019, which however was delayed for suspect reasons. The associated coupon with this issue is expected to be in excess of 7% based on a peer analysis using European banks, resulting in a whopping €10 million added interest expense annually. This is considerable, especially in the context of an expected annual net profit of circa €63 million according to our estimates for FY2019.

Herein lies the paradox, whereby the regulatory burden and associated high funding costs placed on the banks by requiring them to hold elevated levels of core capital is eroding the banks’ earnings, and possibly deplete the banks’ capital buffers in bad times or decelerate their build-up in good times.

This effect is magnified for vulnerable banks, which are forced into higher than average funding costs, which can have an adverse impact on banks’ ability to withstand macroeconomic shocks and endanger the overall stability of the banking sector. This goes against the original scope of having the regulation in place, and is a perfect example of the tangible cost of regulation.

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