First of all, I would like to apologize as unforeseen events have prevented me from being with you tonight to celebrate the 20th anniversary of the Annual Conference of Financial Institutions organized by UBS Spain. Instead, I have offered Daniel Vázquez-Villanueva to write a brief account of how the current financial situation differs from that of two decades ago. In this way, I remind you of two basic principles of the financial markets with which you work.
The first is the presence of uncertainty: ex ante, my expectation was to join you for this dinner, but ex post, this has not been the case. And second, there is no free lunch: in this case, there will be no free dinner. The price to pay, on this occasion, will be the dinner speech, even if delivered remotely.
The first obvious difference over these past 20 years is that in 1999 I was 20 years younger, and, believe me, that is the most relevant difference for me. Jokes aside, I will structure my comments around three blocks. First, I will briefly review the evolution of the economy. Second, I will summarize where we were 20 years ago and where we are now in the field of financial sector regulation. Finally, I will briefly discuss what has happened in the banking sector. And, above all, allow me to offer a Spanish perspective.
The Economy
Twenty years ago, the euro was taking its first steps. It was a moment of pride for all of Europe, not without doubts. In my case, having worked at the European Monetary Institute, I recall the words of our then-president, Alexander Lamfalussy, in 1994, stating that the euro had barely a 50% chance of becoming a reality. It was not easy; its success should not be taken lightly. Twenty years later, the euro has survived the biggest financial and economic crisis since the Second World War. In retrospect, we knew that the euro’s true test would come with the first crisis, but no one expected a crisis of such dimensions. The crisis caused Spain to lose 10% of its GDP, which led to a tragic 27% unemployment rate and wiped out almost half of our banking industry. Not only has the euro survived the crisis, but the institution behind it, the ECB, has been by far the most effective bulwark in defending it and fighting the crisis. And for Spain, it was undoubtedly much better to face the crisis within the institutional framework of the euro.
This may surprise some of you of Anglo-Saxon origin, but this has been my position for the last decade, during which I have held numerous conversations and interventions to deny that Spain would have fared better outside the euro. Old enough to have lived through the last substantial devaluations suffered by Spain in 1992, 1993, and 1995, I prefer not to have to face the impact of devaluations—a terrible tool for income redistribution—on inflation and on the country’s social and institutional structure.
Of course, this does not mean that everything went well. The permanent reduction in interest rates brought about by the euro led to an unprecedented real estate bubble in Spain, which was followed by a sector collapse. Other policies, including fiscal policy, structural reforms, and, why not say it, financial regulation, should have been more proactive in addressing these initial distortions, but they were not.
And despite the impact still suffered by our social fabric, the Spanish economy has been able to recover with an export-oriented productive structure, and has been gaining market share in both global markets and the euro area itself. In fact, we continue to grow above our euro area counterparts. In summary, from a purely economic point of view, the euro is and has been worth it.
Today, we can observe an increasing synchronization of growth and economic cycles within the euro area. If interest rates at the beginning of the euro were too low for some countries (for Spain, obviously, they were) and too high for others, the situation is now entirely different. The upcoming economic cycle will be the litmus test to determine whether the euro area is now better prepared to face a growth slowdown. My only fear does not concern the synchronization of growth, but a possible repetition of the 2012 sovereign debt crisis, in which Southern European families and businesses faced a sudden and disproportionate increase in interest rates and financing costs.
Banking Regulation
Twenty years ago, the Basel Committee initiated discussions on Basel II. We can say that regulators then fell into the scientific illusion of the power of the finance field, of quantitative models for pricing financial products, and of the capacity large banks had to manage their risks. Consequently, they were willing to let banks use their internal models to calculate PDs (probability of default), EADs (exposure at default), and LGDs (loss given default). In short, they blindly trusted the technical competence of banks, particularly large financial institutions.
Banks were ambitious enough not to be entirely satisfied with what Basel II offered them. Their aspiration was to opt for what was then called Basel III, that is, full portfolio models, which would allow for the recognition of risk diversification across the bank’s entire balance sheet for regulatory capital purposes: that was what Basel III meant in those pre-crisis days!
As for corporate conduct rules, they were relatively simple, with very basic rules on the need to avoid conflicts of interest, fiduciary duty to clients, and the fight against insider trading.
Twenty years later, we have a Basel III (some even argue we already have a Basel IV), but of an entirely different nature than desired in those days. This Basel III Accord is much more intrusive in every aspect, reflecting a complete loss of confidence by supervisors in the technical suitability of the financial industry. In fact, it is even worse: they have also lost faith in the character, understood as the ethical foundations, of banks, in their firmness and moral excellence, in their ability to operate with simple principles such as avoiding conflicts of interest or respecting fiduciary duty towards clients. This has been a devastating loss for banks. And I fear that the interventionism of regulators, supervisors, and the judiciary has not yet reached its peak: I do not rule out that we may even see price controls extend to all aspects of banking activity.
This explains why we not only have higher capital requirements, both in volume and quality, but also liquidity requirements, resolution rules, which include overwhelming demands in terms of resolution capital (MREL), stress tests, ICAAPs, ILAAPs (Internal Capital Adequacy Assessment Process), and governance rules, among many others. In the area of conduct rules, things are no better: we are subject to MiFID II and PRIIPs, immensely complex and intrusive conduct rules that offer no safe harbor to the financial industry. Furthermore, some good ideas from the new regulatory paradigm, such as the concept of capital and liquidity buffers, may never be used. Can you imagine a bank’s Liquidity Coverage Ratio (LCR) below 100% in times of stress? No, the interaction of rules and markets ensures that banks, instead of letting the liquidity buffer decrease, compete with each other to demonstrate their strength by having LCRs well above 100% in stressful situations.
But for me, the two most worrying aspects of regulation after these 20 years are: First, the immense complexity of the new rules. The consolidated text of Basel III published a few weeks ago by the Basel Committee is 1,868 pages long; MiFID II has 5,000 pages of text, and the set of EU Resolution rules (Regulations and Directives) is longer than the Bible. Why is this complexity so damaging to entities? Because it is almost impossible to understand how the interactions of all these rules work. It is a black box, whose functioning we will only know when we are confronted with the results. For example, although we cannot yet know the consequences it will have, we do see some impacts, such as the disappearance of equity research from small boutiques or research aimed at low-volume stocks as a result of the application of MiFID II. The problem is that we may not be aware of the results until it is too late, that is, until a new crisis erupts. Generally, the risk of complex regulation is regulatory capture by companies. But, with this level of complexity, the risk, above all, is the total blindness of both regulators and regulated companies regarding the risks faced in the medium term.
The second aspect of my concern regarding regulation relates to its architecture: we are regulating by type of financial institution and not by type of activity. The problem with this type of regulation is that it is very prone to arbitrage. In fact, we already saw this in 2007, as AIG, monoliners, SIVs, Lehman Brothers, and Bear Stearns were not banks and were not subject to banking regulations: they were insurance companies, brokers, and SPVs (special purpose vehicles), among other non-bank agents. Now, in this world of technical revolution that is blurring the line between financial companies and technology companies, the new regulatory paradigm will be even more prone to capital arbitrage and the displacement of risks towards the unregulated shadow banking sector (including in this case fintechs and bigtechs).
Allow me to conclude this part by returning to the theme of the lack of faith in the technical capacity and conduct of banks. If we want to survive the next century, we must mend the relationship between banks and regulators, the political establishment, the judiciary, and society as a whole. Otherwise, we can expect regulation to move in the wrong direction and become even stricter, more inflexible, complex, and overwhelming.
The Banks
In 1999, banks were fully engaged in the Originate to Distribute (O to D) model, whereby they assumed risks, not to hold them on their balance sheets but to package and distribute them to other operators in global financial markets. The interrelationships in this O to D model were abundant and complex: interbank markets showed feverish activity, thus linking risks between banks; international banks used their structure to raise capital and liquidity and send them to fast-growing geographical areas and business lines; and the presence of banks in risk markets was also abundant, with SIVs, CDOs, squared CDOs, etc. The industry’s leverage at that time was brutal: banks operated with as little as 1% of high-quality capital relative to assets or 2% of Risk-Weighted Assets (RWAs). Think about it: we were so confident in the technical capacity of banks that an impact of more than 1% on an entity’s balance sheet value was unthinkable. From today’s perspective, this faith seems terrifying.
In those days, supervisors were satisfied, and their concerns were directed towards the world of hedge funds: in fact, Long Term Capital Management (LTCM), a hedge fund managed by several Nobel laureates in Economics, had to be intervened and liquidated in 1998. That was the great fear then: a hedge fund crisis!
Twenty years later, we cannot say that the Originate to Distribute model has been abandoned, but we can barely detect it. The interbank market has disappeared, cross-subsidies between countries and business areas of large international banks have been severely restricted; and risk transformation continues, but in a much more limited way. Meanwhile, a potential crisis of a hedge fund remains the red herring pursued by global financial supervision.
At this moment, banks are facing:
– A low interest rate environment that destroys the value of a bank’s core activity, maturity transformation;
– Very low balance sheet growth, as households and businesses continue to deleverage after the crisis;
– Higher capital requirements, which have a direct impact on return on equity (ROE). The math is simple: tripling capital requirements means a denominator three times larger and, therefore, ROEs reduced to one-third of what they once were;
– Resolution and capital rules, MREL, and resolution plans;
– Higher liquidity buffers (LCRs) and limits on maturity transformation (NSFR or Net Stable Funding Ratio);
– Increased competition fostered by authorities through Open Banking and PSD2;
– And, last but not least, the fourth industrial revolution and the emergence of fintechs and bigtechs as new competitors outside the regulated system.
I could add the challenge of sustainable finance to the list, but since we still have a couple of years before it hits us hard (it’s already here, but not yet with the force I perceive in the future), I prefer to set it aside for now.
Seeing all these challenges, it seems a miracle that banks are still alive and kicking. In fact, if 20 years ago someone had told me that banks would be able to cope with all this, I would not have believed it. In a way, banks have been performing better than expected.
Allow me to briefly refer to Spain, because in the banking sector Spain was different, as an old TV commercial of ours used to say, both in positive and negative ways. The first difference is the banking model. The good news is that we did not embark on the Originate to Distribute model. The bad news is that we suffered a traditional banking crisis that was exacerbated by the effects, first, of the international financial crisis and, later, by the sovereign debt crisis that so severely affected the Eurozone periphery. By traditional crisis, I mean a poor assessment of credit risk by banks that rapidly expand their balance sheets. And the Eurozone crisis meant a sudden cessation of financing flows, a sudden stop, typical of emerging countries, but which occurred in the heart of Europe.
In the midst of this crisis, the model of our commercial banks and, in particular, our international banks showed its resilience. These were commercial banks, with significant shares in local markets, locally funded with deposits and without cross-subsidies from the parent company, whether in terms of capital or liquidity. This business model, which was designed to protect Spain from the volatility of Latin America, ended up, not without some irony, protecting Latin America from the turbulence of the Eurozone.
But we also had other peculiarities that made our financial system weaker. 40% of the Spanish banks’ balance sheets changed hands during the crisis, and entities were absorbed through mergers or through the intervention of authorities and their subsequent allocation through open tenders. From 45 banks of a certain size, we have moved to 13, for now. The savings banks sector disappeared as such, either due to individual crisis or their transformation into private commercial banks based on shares. The lesson here was twofold: first, that property rights without a clear definition end up creating suboptimal corporate governance structures that can lead to poor risk management; second, that banks must always have the capacity to increase their capital through the issuance of shares, and in particular, they must be able to do so during a crisis.
Conclusion
As the false Chinese curse says, I have had the privilege of having lived through interesting times for the past 20 years. I am more than willing to give up that privilege and live a few less interesting years. But I fear that the challenges I have mentioned guarantee that we will continue to live under the curse until the end of our professional careers which, in my case, I hope will not extend for another twenty years.
José María Roldán, Chairman of the Spanish Banking Association
