The cost of implementing banking sector regulations has risen by an annual average of 16% since 2015 says a recent study by the the Luxembourg Bankers Association (ABBL) and major accounting firm EY. This has been a theme across the financial sector, yet even so there remain players willing and able to bend and break these rules. Meanwhile smaller banks are struggling to manage rising costs, creating their own imbalances.
It cost the Luxembourg banking sector €548m to implement regulations in 2019 said the ABBL survey, a figure which amounts to 8% of all costs. A total of 14% of all banking employment is focused on regulation. Well over a third of investment made by the banking sector in 2019 related to regulatory projects, with this value rising to 52% for the smallest banks.
Banking sector will shrink
While there is no doubting the reduced desire to trust banks after the global financial crisis and the drive to eliminate money laundering, there are consequences to these increased costs. While there are currently 126 banks in the Grand Duchy, Claude Marx, the director general of Luxembourg financial sector regulator CSSF has repeatedly predicted that this number will fall below 100 in the coming years. He cites the costs of regulation as a reason, alongside the investment needed for digitalisation. These costs will see smaller players close or be absorbed and ensure that certain business models no longer match market requirements.
At a press conference on 30 May, Marx expanded on this point saying: “an unprofitable bank is a dangerous bank.” He said this was because they will be tempted to “seek profitability by taking ill-considered risks that endanger their clients’ assets.” This latter risk is present whenever institutions become fragile, with or without regulation. Yet in a statement, the ABBL repeated its calls for “a more proportionate approach in the field of banking regulation to maintain diversity and to ensure eventually a more resilient banking system.”
Resilient, but …
Advocates of the current regulatory regime point to the resilience of the financial sector during the Covid crisis so far. “The banking sector is solid, in both financial and organisational terms,” Marx added in a recent press interview. Luxembourg banks maintain high equity capital ratios of around 24%, compared with a required minimum of 8% and loan loss provisions increased by €600m last year. This solidity has shown up in results, with aggregate profit before tax and provisions of €1.32bn for the first quarter, a 13.7% increase from a year earlier, according to the CSSF.
In the fund sector too, the industry is patting itself on the back for its resilience during the Covid crisis. Yet the question remains here too, would this have been achieved without the unprecedented monetary and fiscal support from global governments and central banks? People close to the CSSF have noted that although the vast majority of market participants respect the regulatory environment, there are still a minority of cases where regulations such as liquidity risk management policies, procedures and operational controls fall short.
Woodford-esque abuses continue
It is now more than two years since the high profile, UK-based Woodford Equity Income Fund crashed. This UCITS fund collapsed in a blaze of media coverage under the weight of illiquid investments which had turned sour; something that should not have happened given that UCITS are designed principally for liquid assets. Yet despite this warning, national regulatory authorities such as the CSSF are seeing UCITS managers investing in unlisted securities without extensive liquidity analysis. Although these are isolated cases, it demonstrates that regulation and supervisors can only do so much in the face of professionals determined to ignore the rules.
The ABBL and eight other European banking associations have launched an initiative to promote a debate on proportionality in banking regulation. “The aim is not to undo sensible regulation: the same capital and liquidity requirements should continue to apply for the same risks,” Gilles Pierre, head of banking regulation at the ABBL. He called for the identification of regulatory measures with “costs clearly out of all proportion to the associated benefits,” adding that these risked endangering financial stability. He pointed to measures to alleviate regulatory oversight on small and non-complex banks in the new CRR2/CRD5 rules as an example to be followed.
Regulatory reform agenda
There is ample scope for a review given the list of regulatory measures up for review in the coming months. A review of the consumer credit directive is expected to extend its scope into other areas of lending, but may introduce simplified rules on pre-contractual information and assessing credit-worthiness. AML rules are to be reviewed again, including the establishment of a dedicated EU authority. For sustainable finance, as well as completing the green investment taxonomy, there will be efforts towards extending this into social investment, the creation of ecolabels and standards, proposals on green bonds and more.
A new set of Basel texts are due, postponed during Covid. In the autumn there will be a review of the Alternative Investment Fund Managers Directive which will have relevance for asset managers and also possibly also depositary banks. Then the markets in financial instruments (MiFID) regulation will be reformed with a new directive in 2022.
The bank recovery and resolution directive is also being reviewed, with a view to allowing for an orderly resolution of medium-sized banks, institutions that are currently not covered by a European framework. Then there could be the creation of a European deposit insurance scheme, which has been discussed for a number of years.
For investment funds, it remains to be seen to what extent the US will diverge from EU rules on ESG investing. Also for Brexit, the UK government will be tempted to diverge from EU rules. Both will create extra regulatory costs for concerned market players. We also don’t yet know whether EU regulators will enable delegation to UK asset managers and new rules might add regulation-related complexity.