Karl Marx, a bank reformer if ever there was one, once observed that “philosophers have only interpreted the world in various ways; the point is to change it.” For better or worse, the global banking system has outlived the Marxist onslaught. Now that system is frustrating a new — and, albeit, more conventional — generation of would-be reformers.
The sticking point for today’s financial regulators is the need to turn theory into reality — a challenge that Marx himself might have referred to as praxis. Why is that the case? To some extent, banks may be expected to resist change, especially to the extent that it minimizes company profits, or, more to the point, compensation.
That’s only part of the answer, though. The real difficulty lies in the complexity of the markets, and the difficulty in understanding how the markets will react to new regulations. As Representative Jeb Hensarling said last year after the White House and lawmakers reached agreement on the 2,000-page-long financial reform bill in the U.S. — “My guess is there are three unintended consequences on every page of this bill.”
The unintended consequences of reform are now revealing themselves in the U.S. and Europe. One of their key goals is raise the level of capitalization among major lenders, creating a cushion that will help banks absorb any future losses and minimize the chances of another public bailout. And that cushion could come in handy — all of the European banks have various degrees of exposure to the ongoing sovereign debt troubles in the EU. Regulators are trying to put a bailout for Portugal in place, Spanish banks are shaky, and S&P today downgraded the debt of Greece and Portugal.
The new capital rules are known as Basel III, a global industry standard that was agreed upon last fall and will be implemented by 2013. Those standards will help raise Tier 1 Capital levels for institutions such as UBS and Credit Suisse to the 12 to 14 percent range, according to research by Barclays Capital. At the height of the financial crisis, those ratios of common equity and reserves to assets dropped to the low to mid-single digits. Banks also must boost their levels of Tier 2 Capital, which includes debt.
As banks issue new debt to help boost their capital levels, they will need to match the maturity of their assets and liabilities. The old practice is issuing cheap, short-term debt to fund more expensive long-term obligations and pocketing the difference is now frowned upon. That cycle crashed to a halt as short-term interest rates rose, boosting borrowing costs.
This is nice in theory, but regulators have not figured out who is going to buy all that paper. The investors are on strike. Insurance companies traditionally are the main buyers of bank debt. But their regulators are discouraging them from purchasing senior bank debt.
One of the challenges, explains Anna Pinedo, a partner with law firm Morrison & Foerster, is that under certain circumstances, new regulations may require that bondholders incur losses (“haircuts” or conversion to equity) before taxpayers are required to contribute to any bail out of the financial institution. The extent of this “bail in” is discretionary and the exact details remain uncertain. The bail in notion is a feature of the UK bank resolution scheme and is under discussion in the EU Commission proposal, too.
“Regulators may have significant discretion relating to the haircut for senior debt holder claims. As a result, investors may be wary of senior debt issued by financial institutions in Europe. They may have concerns about pricing the risk of a ‘bail in.’ Investors are looking at subordinated debt for which they may be better compensated. Also, investors are considering covered bonds and other secured bonds, which would not be subject to these bail in features,” Pinedo said.
Insurance regulations, known as Solvency 2, would discourage insurance companies from holding long term bank debt, although Basel III encourages less reliance by financial institutions on short-term debt.
In the U.S., the picture may be a bit more complex. If certain financial institutions are required to issue contingent capital instruments by regulators, European financial institutions may be able to obtain more cost-efficient funding. The tax regime in many European jurisdictions would permit issuers to deduct payments in respect of various contingent capital instruments. In the U.S., in the absence of guidance from tax authorities, it is not clear that U.S. issuers would be able to achieve tax deductibility for certain similar products, according to Pinedo, which may raise competitiveness concerns.
Regulations aren’t helping matters from an equity perspective, either. Credit Suisse has lowered its estimated return on equity to the mid-teens. “Swiss regulation is driving a sharp increase in capital per unit of assets, eroding the banks’ ROEs as well as hurting their competitive positions,” Goldman Sachs European banking analysts said last month in an investor report.
Regulators, afraid of appearing weak, didn’t give bankers much say in how the new regulations should be written. They don’t appear to be ready to back down now, either.
Of course, should worse come to worse regulators could socialize the whole process and buy the bank debt themselves. But that would put the taxpayers on the hook, contradicting one of the major goals of bank reform. Of course, capitalism has had its share of contradictions before.
