How can security markets finance long-term growth?

1. Diego Rodriguez Palenzuela Capital Market and Financial Structure Directorate Monetary Policy How can security markets finance long-term growth? Brussels 1 October 2013

2. Motivation • The post-crisis regulatory landscape should address the pitfalls that led to the 2007-08 and 2010-12 financial crises, based on the analysis of their causes. • Yet, worries have been voiced whether the transition costs could hamper the on-going recovery, so that the transition to the new (better) equilibrium may be more protracted and painful than foreseen. • As a case in point, a scenario of frontloading by banks of capital requirements has materialised. Observers claim that frontloading by banks of capital requirements has had a contractionary impact on output. • However, looking through the transient impact of banks’ recapitalisation, higher capital ratios should bestow resilience to the medium term growth outlook • We focus role of securities markets for enhancing resilient LT funding

3. Scope: the banking regulations considered

4. Higher capital requirements usuallymet through more earnings retention,equity issuance and/or deleveraging and risk weight optimisation • Liquidity requirements: Should lead to higher quality assets and better matching of asset-liability maturities, but also to lower net interest income when yield curve upward sloped and potentially also more reliance on central bank funding • OTC derivative: Collateralisation is expensive • Banking separation: tends to limit the economies of scale between activities • In the transition to a new steady state, adjusting to new regulationis likely to be detrimental to bank income; banks charge higher margins and tend to tighten provision of credit(e.g. Berrospide and Edge (2010), Francis and Osborne (2012), Maurin and Toivanen (2012)) Channels whereby bank adjustment affects activity

5. Capital requirements (% RWA) Liquidity requirements ratios Progress made regarding capital and liquidity requirements Sources: ECB computations based on BCBS (internal version of the Basel III monitoring exercise, September 2013. Note: Unpublished and confidential • Important progress since end 2010: banks have frontloaded. • Distribution matters. Looking through the banking sector – and excluding the part under restructuring scheme – some gaps remain. • More recently, the attention has turned to the leverage ratio as some suspicion as emerged around the calibration of risk weights.

6. Change in capital ratios and in stock prices CDS spread to sovereign and Tier 1 capital ratio Did benefits already materialised? Source: ECB computations based on DATASTREAM, listed banks. Note: CDS spread from the 5 year sovereign bond averaged over 12Q2-13Q2 (LHS) average over the first two quarters of 2013 reported to the average in 2009 (RHS). Some positive effects of the increased confidence in the banking system could have started to materialise with lower funding cost (lower liquidity risk and default risk) Indeed, negative relationship between solvency ratio and CDS spread would suggest that higher capital ratios are associated to lower funding costs. These effects are difficult to capture with structural models (unless banks can fund themselves directly on the non-deposit margin). Previous analysis may overestimate the costs.

7. Contributions(de-meaned annual rate of growth in percentage, contributions in percentage points) Direct tapping of the market by corporations to NFCs loan growth to NFCs debt issuance to investment growth Source: ECB estimations. See Maurin (2013) Loans affected by weak overall demand and specific factors entrenched in the banking sector (regulations, funding, risk…). Strong debt issuance activity party resulting from adverse access to bank loans from end 2011 until beg. 2013. Possible substitution. But largely resulting from idiosyncratic factors (large corporations in a few countries). Adverse credit environment exerts an overall negative impact on business investment.

8. Key factors for enhancing securities markets [ Shorter term ] • Conjunctural • Structural • Adverse selection • Transition to new regulations • Information infrastructure • Taxes and legal harmonisation • Better instruments • Ratings • Development banks • “Steady state” regulation [ Medium term ]

9. Information infrastructure • Problems in accessing quality information remain major barriers for better capital market funding , in particular of SMEs • Part of these challenges have been mitigated through the use of scoring companies and credit registers … • … and the establishment of the European Data Warehouse, [banks have been required since January 2013 to provide loan level information on SME securitisations, in accordance with a standardised template, as a necessary condition to be eligible as collateral for Eurosystem credit operations] • Improving the transparency and quality of SME loan data – including on loan performance – would support investor confidence and provision of capital market funding, especially of SMEs

10. Higher harmonisation of key legal procedures • Need to give priority to the longer-term goal of achieving better integrated capital markets • Currently European equity markets are relatively small and fragmented and the cross-border ownership of corporate bonds is also underdeveloped • Fostering the integration of European equity markets will require inter alia a higher harmonisation of insolvency legislation • [See Andre Sapir and Guntram Wolff (2013) The neglected side of banking union: reshaping Europes Financial System; note for the Informal ECOFIN 13/14 September 2013, Vilnius ]

11. Reviving securitisation markets • Securitisation markets can provide an additional source of funding for banks, affecting positively their capacity to finance economic growth, but since 2008 confidence in the securitisation industry is damaged • This is as a major constraint on SME access to finance: AFME estimates that ca. €200‐300 billion of funding could be provided through securitisations sold to third party investors, including insurance companies, pension funds, banks and others • Reviving the securitisation market in the EU requires achieving the right balance between financial stability and the need to improve maturity transformation by the financial system

12. Distribution of ABS held by European bank by rating (%) Impact on risk weights of the regulatory change (%, 1 year LHS, 5 years, RHS) Estimating the impact of the regulatory change envisaged for securitisation Sources: ECB computations based on JPM Sources: ECB computations based on BCBS, Dec. 2012 and JPM • EA net flow of ABS: 200 billions in 2006 (mostly RMBS, housing loans), around 20% of new loans granted to the non fin private sector. • Increase in average risk weight, from 70% to 90% (under RBA, one approach), and in minimum capital requirement, to 7%, with implications for bank capital

13. Concluding remarks Very difficult to disentangle the contributions of demand, policies and regulatory changes on actual credit outturnsA large part of the capital and liquidity adjustments has already occurred. In addition, some positive effects appear to already be materialising Regulatory uncertainty remains harmful and to be avoidedLooking forward, a key challenge remains in aspects affecting the banks’ funding side (e.g. ABS and shift to secured funding); Clear scope to improve scope for securities marketsfor SMEs through a variety of instruments

14. Thank you for your attention