To avoid any misunderstandings: bank regulation makes sense. But it should be appropriate, coherent and internationally coordinated. This column is not a plea against regulation. Instead we believe that the developments in the USA should be used as an occasion to rethink the regulatory landscape in Europe, without any preconceptions regarding the outcome.
US President Trump has started to implement another election pledge. The regulation of banks is to be simplified. On Friday he signed an executive order to examine the necessity of the individual regulations. This means that the Dodd-Frank Act and the Volcker Rule, which imposes restrictions on the own-account trading of banks, are to be subject to a review. The objective is to simplify loan granting and make it somewhat easier for banks to manoeuvre.
This development stirs unpleasant memories of the last financial market and banking crisis. After all, this crisis rattled the very foundations of our social order, and the consequences are still evident today. The fear is understandable. A development of this kind should never be repeated. The danger of the global economy actually sliding into a deep depression would be enormous. In the last crisis, the bold actions of the central banks and governments spared us this fate.
In past years, the capitalization of banks has tangibly improved and the equity capital is now much higher than it was before the last crisis. A sizeable buffer has thus been built up for crises and the latitude for regulation widened. In recent years, the regulatory authorities decreed a large number of provisions without ensuring that they were all harmonised. A critical view of the regulatory landscape is therefore fully warranted. And this does not automatically lead to unbridled deregulation.
A critical appropriateness test and impact analysis of the entire regulatory regime could create a good deal of relief without at the same time creating a surge in the danger potential in the banks’ balance sheets for financial markets, enterprises and countries. Many of the regulatory measures of recent years have made sense. But surely this is also a good time to adjust or even delete those regulations which make no sense or have become unnecessary. Hence, the sweeping criticism against these measures stemming mainly from Germany is entirely unwarranted.
With the buffer capital of banks now at a higher level, this can also serve as the starting point for the theoretical discussion on an extensive simplification of regulation. The regulatory density of banks depends essentially on how high their equity capital is. The higher the equity capital, the more loosely the strict rules are applied, or they are not applied at all. From equity capital of 20 percent upwards, a large part of the regulations could be omitted. Based on a rational cost analysis, the banks could then individually decide the optimum amount of equity capital for them. Unfortunately, no regulators or politicians are currently pursuing this approach; instead, they insist on rigidly adhering to the established inflexible regulatory methods.
In the USA, the process of rethinking bank regulation is under way. In Europe we are a long way off from this. This will highlight even more the greater differences in bank regulation between the USA and Europe. However, the tighter regulation of European banks is proving increasingly disadvantageous for them in international competition. If this development continues, the less rigidly-applied regulation in the USA will enable US banks to gain market shares on account of their competitive lead and thereby become more profitable and boost their total assets. The difference in relation to European banks will become even more obvious and European banks will fall even further behind in international competition. The medium-term avoidance strategy will likely be that of European banks strengthening their own particular business units in the USA in order to profit from the prospect of more favourable regulatory conditions there. Were this to happen, there could no longer be any talk whatsoever of a level playing field in bank regulation.
In recent months, US banks have been able to profit from another advantage in relation to European banks – that of rising interest rates. The US Federal Reserve raised key interest rates for the second time last December to 0.5% – 0.75%. In the fourth quarter 2016, the yield on 10y US Treasuries climbed from 1.60% at the end of September 2016 to 2.45% at the end of 2016 and has been hovering around this rate since then. During the course of 2017, we expect the Fed to make two more rate increases in the USA and yields to rise slightly.
The higher interest rates and yields in 2016 will have a positive impact on the earnings development of US banks. According to US banks, an increase in the US yield curve by 100 basis points leads to an increase in net interest income of between 2 and 3.5 billion US dollars. In other words, the profitability of banks benefits from rising interest rates and yields. This applies not only to the USA but of course also to Europe and the Euro area. In the Euro area, the ECB as responsible regulator is calling on the banks to strengthen their profitability, yet is itself putting up a high obstacle in the way to achieving this in the form of the very low interest rates.
The regulatory and business conditions for US banks could further improve in the months ahead. After some delay, this trend could also reach Europe, albeit in a somewhat weaker form. All in all, however, the banking sector in the USA has likely seen the bulk of the burdens. Whether this is the case in Europe is still unclear but it would be hugely detrimental to European banks if this were not so.