Supervision and regulation have changed

Besides banks, other parties are also crucial in monitoring the investment behaviour of society, and by extension in monitoring the risk profile of the financial institutions that guide it. Legislators and macroprudential regulators can, for example, influence the investment behaviour of society through legislation or interest rate policy, and so exert direct influence over the risk profile of the financial sector. They can also steer that investment behaviour, and therefore also that risk profile, in a certain direction with targeted actions, both within the financial institutions and in society. This is truer today than ever before.

Twin Peaks

That is why not only the banks themselves have changed, but why the supervision of financial institutions has also undergone a genuine metamorphosis. Since April 2011, the Twin Peaks II legislation has governed the supervision of Belgian banks. Within that framework, the National Bank of Belgium has been given the power of micro- and macroprudential supervision of Belgian banks while the Financial Services and Markets Authority (FSMA), among other things, handles the supervision of financial markets, listed companies and the marketing of financial products.

In a new regulatory structure, agreed at EU level, a European regulator (the Supervisory Stability Mechanism) and the national regulator (the National Bank of Belgium) will each have sufficient scope to exercise macro-economic supervision beyond the country’s borders. The Twin Peaks II rules give the National Bank of Belgium as prudential regulator the power, for example, to overturn strategic decisions if these could jeopardise the stability of the bank or the financial system. When the Single Supervisory Mechanism (SSM) comes into effect, the scope of bank regulators will be strengthened on a European scale.

Banking union 

The SSM is part of the measures relating to the banking union, which will significantly alter the way banks are controlled. The banking union must ensure harmonisation within Europe of banking supervision, the deposit guarantee scheme and the settlement procedures for financial institutions in difficulty.

By increasing the scope of the regulators, these can identify possible causes of financial instability before they actually manifest themselves. In this way, vulnerabilities of the system are reduced and the impact of crisis tempered. Shifting banking supervision to a higher level than the national is also necessary because the different players in the world economy are interconnected in such a way that the financial system can no longer be supervised within the isolated context of national borders. After all, recent history shows that a property crisis in the US can lead to financial problems the world over.

Giving the European regulator more scope in turn allows him to be able to identify possible causes of crises before they occur, and take countermeasures where this proves necessary. A financial sector cannot single-handedly guarantee the health of, for example, a property market or other macro-economic activities, because such markets interact with various individual – and sometimes non-banking – commercial players. Regulators are often better placed to do this than the banks, which find it harder to take action against, for example, imploding property markets, or against the excessive indebtedness of public authorities or of society – important seeds of the two previous crises. By, for example, tinkering with base interest rates, central banks can after all influence the investment behaviour of society.

New regulation 

Besides supervision, the regulation of banks has also changed significantly. As stated above, numerous (international) rules have been introduced that curb banks’ freedom to take risks. The Basel III rules require financial institutions to hold more capital and liquidity (i.e. immediately available capital) against their outstanding investments and loans. In concrete terms this means, among other things, that the hard core capital of the financial institutions more or less has to double to be able to continue to provide the same volume of credit. For Europe, the Basel III rules were translated into the CRD IV Directive. The rules will be gradually implemented from this year and must be fully in force by 2018.

All these regulatory interventions will ensure that the banks are better able to keep their risk profile under control. They will also give the regulators more insight and scope to intervene if that proves necessary.

The new regulations, the banking reform projects and the new powers of the regulator (national, European and international) will lead to a structurally healthier financial sector (and in many cases have already done so). Risk must also be handled in a healthy manner in the future, but complete risk aversion must not become an end in itself. After all, the fact that the sector is undertaking to keep its risks low, and that the regulator is also encouraging that behaviour, does not mean that every risk can be predicted or avoided.

Impact on profitability: Study KPMG

But the measures also have far-reaching consequences for (the profitability of) the financial sector. KPMG, an international network of consultants, charted the impact of the various regulations on certain crucial financial parameters of the Belgian banking model.

The analysis estimates the impact on Belgian banks’ costs of

  • the (Basel III capital rules and their European implementation via) CDR IV
  • the bail-in (a European measure that requires non-first-ranked creditors such as long-term investors or bond holders to intervene to help rescue banks in difficulty in exceptional cases)
  • the financial transaction tax (a tax on transactions involving securities, derivatives, etc.) (See How does the financial transaction tax work?)
  • the various banking levies (deposit guarantee tax, financial stability contribution, subscription tax)

Among other things, the influence of these rules and charges was investigated as regards:

  • hard core capital or Core Tier-I capital
  • leverage ratio (the relationship between equity and the balance sheet total)
  • liquidity coverage ratio (LCR, a series of criteria relating to liquidity that must be met by a financial institution to be able to survive a stress situation of 30 days)
  • NSFR or net stable funding ratio (a benchmark that encourages financial institutions to bring their financing into line with the terms of the loans or bonds on the assets side of their balance sheet)
  • return on equity (ROE), that expresses net profit in relation to equity
  • cost-to-income ratio (C/I), a ratio that expresses profitability by dividing expenses by income

The KPMG study shows that the Belgian financial sector scores highly in several of these parameters. With regard to Core Tier-I, leverage ratio, LCR and NSFR, financial institutions in Belgium achieve the desired level or very close.

Where the return on equity (ROE) and cost to income ratio are concerned, however, the Belgian banks are still far from achieving the desired targets. All manner of banking levies (see A few levies on banks) have a significant impact on the profitability of the sector.

If policy remains unchanged, regulations and levies will significantly reduce the profitability of the financial sector in Belgium, according to the KPMG study. Significant corrective measures will have to be taken to keep profitability at a level that allows banks to finance the economy in times of low and high economic growth. At that point banks will, for example, have to cut costs, or they will have to increase the interest rates on their loans.

It is important that any regulation would take into account the principles of proportionality. She also needs to leave open the possibilities for banks to diversify and thus better spread risk.

All these levies are in addition to the increase in financing costs, which is a direct consequence of the measures relating to bail-in and the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) introduced under CRD IV.

The bail-in makes financing more expensive because lenders demand a greater risk premium from the banks to which they provide credit. The LCR and NSFR push the cost of financing up because more liquidity and more (costlier) credits with a longer term have to be attracted.

This weighs heavily on the return on equity of the Belgian banks. The ROE target of a minimum of 8% that was proposed for the fourth quarter is far from being achieved: according to the KPMG study, Belgian banks will remain at 4% if the situation stays the same. The cost to income ratio of 65% that the sector was counting on will also not be achieved if policy remains unchanged.

However, the most serious impact on the profitability of financial institutions in Belgium is from the financial transaction tax (FTT), which may be introduced in 11 of the 27 EU Member States. (See How does the financial transaction tax work?)

Belgium is one of these countries and it estimates the impact of the measure at EUR 8.4 billion if no management actions are taken. This is a consequence of the large volumes of financial transactions processed by the financial institutions for their customers or to optimally manage their own liquidity.

A low score in each of these parameters may jeopardise the profitability of the financial sector, and by extension the financing of the economy. This is because a lower return on equity results in a worse cost to income ratio. An insufficient return could mean that Belgian banks fall below the threshold of a healthy cost to income ratio if policy remains the same.