Are banks being deregulated?

After the US authorities published a range of measures in March that if adopted would reduce capital requirements for their largest banks by nearly 5%, this month has brought more limited proposals from the European Commission (EC) and the Bank of England (BoE) around capital rules for investment banks’ trading activities. These proposed adjustments are all aimed at watering down elements of the Basel III framework that was designed in the wake of the global financial crisis.

First, it is important to recognise that regulators’ work on capital requirements never really stops, since they continually monitor banks’ operating environment and may want to address new or developing risks. It is also worth stating that overly restrictive rules can also have a negative impact from a financial stability perspective if they produce unintended consequences, such as reducing lending to certain parts of the economy or making a region’s banking industry uncompetitive against global peers. As an example, tighter bank regulation in the years since 2008 has coincided with strong growth in private credit, highlighting the risk of activity migrating outside the regulated perimeter. Whether this represents a genuine reduction in system-wide risk or a redistribution of risk to non-regulated parts of the financial system remains an open question, and one that regulators are increasingly focused on.

Of course, investors in the financial sector have to price in a degree of risk from regulatory changes. It is important for investors to exercise a degree of caution, particularly where rules are being relaxed, because such periods in the past have led to excessive risk-taking by financial services firms (most notably in the run-up to 2008).

One topic that has drawn occasional headlines around deregulation is the final implementation of the Basel III framework (otherwise known as the Basel Endgame), or rather the proposed watering down of certain aspects of these changes in certain jurisdictions. We have covered this topic in more detail in the past, but in a nutshell the Basel Endgame will make the risk-weighted assets (RWAs) calculations on certain assets and activities more conservative, thus requiring banks to hold more capital against them.

For large investment banks one of the biggest drivers of higher risk weights under this final chapter of Basel rules is the fundamental review of the trading book, or FRTB. The US package from March includes proposed changes to the US implementation of the FRTB to make the use of internal models (which would lessen the increase in RWAs attached to trading) more attractive for banks. Other changes, such as a reduction in the capital “surcharge” for the largest global banks and a recalibration of stress tests, are aimed at softening the overall impact of higher risk weights. Overall, the package is estimated to reduce overall capital requirements for the largest banks by around 4.8% from current levels (even more for smaller banks), marking a clear shift towards a more accommodative stance from US regulators.

By contrast, the proposals published by the EC and the BoE this month are aimed squarely at adjustments to their implementation of the FRTB, with a view to keeping their major investment banks competitive with US peers. These proposals will not result in any material reduction in capital requirements from current levels – they are aimed more at neutralising the incremental impact of the FRTB on capital requirements going forward – and at this stage we have seen no decisive action by European authorities to provide other forms of capital relief for banks like we have seen in the US.

Another area of focus for those watching closely for signs of “deregulation” is the process of simplifying banking regulation that was kickstarted by a European Central Bank (ECB) taskforce last December, with one of the key targets being the rather complex collection of capital “buffers” European banks are required to maintain, all for slightly different reasons. There are some less contentious and rather technical measures around things like reporting and disclosure requirements that we suspect will be adopted relatively easily, but we believe the authorities will take considerably longer debating more ambitious proposals relating to capital bucket adjustments and the potential redesign of capital instruments (if any). Indeed, we are of the view that the ambitious initial proposals in this area will be heavily diluted.

When it comes to the role of Additional Tier 1 (AT1) bonds in the bank capital stack, several proposals are in theory under consideration. It is important to note here that if we were to see an extreme outcome, such as the removal of AT1s from bank capital calculations, we would expect a grandfathering period where existing AT1s would still count as capital, and we think such an outcome would making the calling of these bonds (returning capital to bondholders) almost a certainty at the first call date, as has been the case with Australia’s phasing out of AT1s. In this unlikely scenario, we would also expect the regulator to require banks to raise more CET1 capital to replace AT1s, making banks safer from a creditor point of view (all else equal).

Overall, given the latest changes, we believe the easing bias in the US is undeniable, but it is important to distinguish between “deregulation” and regulators reining in certain elements of a post-crisis framework that arguably went too far.