Dirk Elsner works as a business consultant at Innovecs where he advises banks and medium-sized enterprises in Germany. He also runs a private business insights blog called Wirtschaftblog Blick Log that won 1st Prize last year in the Finanzblog Awards. His blog explores topics relating to business, finance, management and similar issues. Elsner frequently highlights the changes going on in the banking industry in his column for the German Wall Street Journal. He also posts articles on current developments in his blog under the Next Generation Finance tab. As a guest blogger he shares his experiences related to the change of the financial market regulations within Germany and the European Union.
When I embarked on my career as a bank trainee in 1983, legal factors affecting banking were still easy to get your mind round. Compared to today, there were fewer issues relating to the legal framework. Even smaller banks had people with an overview of all key financial market regulations, and they knew what the bank had to do to operate within those regulations.
Over the past 30 years, this situation has changed – radically. The degree of change is more than evident in the new regulation book for OTC derivatives. There are probably more pages in this document on the European Market Infrastructure Regulation (EMIR) – spanning the EU regulation itself, domestic law and other supervisory regulations – than there were in the entire German financial market rulebook 30 years ago. What’s more, you need a whole host of experts to work out what implications the rules have for business operations.
Regulatory requirements currently dictate change in classic banking, with regulations like SEPA, Basel III, Finrep, IFRS 9 and 10, EMIR, FATCA, AIFM, money laundering laws, rating regulations, tax on financial transactions, MiFID II and Mifir. These and other initiatives trickle down a long way into IT systems, customer processes, resolution, risk management, reporting systems, accounting and other areas. This doesn’t just tie up huge numbers of bank employees and external consultants. Regulatory initiatives such as SEPA and EMIR also have a direct impact on companies, and Basel III is definitely having an effect by tightening company financing requirements.
This flood of regulations is the result of the financial crisis, which is an on-going challenge. But when the German Minister of Finance claims that, “The exaggerated deregulation of the financial markets was a mistake,” I’m not sure if I can agree with this statement. Indeed, the way the general public sees it, the financial crisis was brought on by deregulation before 2007. But in the meantime people have serious doubts about this, as Dr. Hartmut Bechtold spells out in his must-read, Thoughts on the Issue of Regulatory Policy and Financial Market Regulation. Apparently, supposed deregulation has reduced neither the number of regulations nor the number of people working for supervisory bodies. On the contrary, both numbers rose continuously, even before 2007.
Unfortunately the financial industry omitted to add the question of whether things are “well” regulated to the agenda. While the associations have been working to deflect criticism of regulations like Basel III onto issues like international competitiveness and equal treatment, it wouldn’t perhaps be wrong to argue more specifically, as indeed Norbert Häring of the Handelsblatt business newspaper did in The Misbelief in Equity Capital. He introduced a number of objections, writing statements like, “Yet it’s scientifically debatable whether revenues resulting from the new regulations, in the form of the anticipated greater crisis protection, exceed costs”. Häring points to the words of the French economist Bernard Vallageas, who concluded that there were hardly any financial crises before Basel I in 1988. After Basel I, there were many, increasingly serious financial crises, despite tighter supervision. In an interview with the Frankfurter Allgemeine newspaper’s FAZIT Blog, the economist Raghuram Rajan called for more simplified regulation. He also pointed to the fact that some of the risk encountered in the financial markets is actually a result of regulation.
Even the supervisory bodies are increasingly distancing themselves from some regulatory measures. For example, the German Federal Financial Supervisory Authority has criticised EMIR and some of its consequences. Specifically, it is concerned about the side effects of derivative guarantee requirements. EMIR stipulates that possible obligations of derivative transactions be secured by first-rate collateral. As there is limited availability of first-rate bonds, banks and other market players are forced to acquire this collateral. They achieve this through instruments like collateral transformation (ie, exchanging securities), thus shifting risk back to unregulated areas.
Without going into it in detail, this highlights the typical course of developments of the last few decades. Regulation initially leads banks to new waves of activity, in order to meet defined requirements. Then, they search for new business models to put themselves in the position to answer customer requirements. And this culminates in an on-going battle with regulators, resulting in regulations becoming even more comprehensive and even more elaborate. Despite this, until now no one has provided a plausible explanation as to how the financial system has then really become safer or better. In his almost legendary paper on The Dog and the Frisbee, Bank of England Executive Director of Financial Stability Andrew Haldane appeals for regulations to be simplified so that the complexity of the financial sector can be mastered.
Another headache for the industry is the proliferation of supervisory bodies. In the 1980s, we were kept busy by the Bundesbank and BaKred (today’s Federal Financial Supervisory Authority, or BaFin). Now the load is distributed across different authorities, often with overlaps. There’s the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA, which oversees capital markets), and the European Systemic Risk Board (ESRB), which is part of the European System of Financial Supervision (ESFS), which in turn is supposed to supervise the financial system in the EU. And each one has something to contribute. And this isn’t the end of it. The Finance Ministers of the EU have decided to pull together direct supervision of banks in the eurozone as part of banking union at the ECB. They had hardly passed the agreement when EU Internal Market Commissioner Michel Barnier tabled a new EU resolution authority for banks, which he did not envisage within the ECB.
A negative knock-on effect of changes for banks is that regulatory reporting and compliance now keeps more people occupied than product development. The regulations are the number one cost driver, and drain energy from financial players who would otherwise have invested in innovation and reinventing themselves. Little wonder that the drive to innovate is waning.
Of course this ebbing in creative flair in the financial sector only really applies to the traditional areas of the industry. Beyond the traditional borders of banking, a plethora of companies have entered the scene in recent years, nibbling away at the value chain between banking and its customers*. This includes well-known Internet and telecommunication companies such as Google, Paypal, Amazon and NTT, plus a string of startups.
I’m lucky in my work that I can hopscotch between the world of classic financial services providers and their customers on the one hand, and next generation finance on the other. I interact with lots of creative geniuses who earned their laurels in the financial sector but moved on because change from within was rare. Many of these creative types even see tightening financial market regulation as an opportunity to enter new product areas.
Because developments like Basel III typically make business financing through the banks more difficult, platforms that line up direct financing between investors and companies have sniffed an opportunity. In Germany, the model is called peer-to-peer credit or crowdfunding, and it’s still very much coming out of the starting blocks. In the United States, financing deals arranged along these lines rocketed past the billion mark some time ago. Institutional investors have discovered a new class of investment and it’s given banks a new way to offer their customers extended services. And, most recently, Google secured a strategic investment through Lending Club, one of the biggest US peer-to-peer lending companies.
We will see in the months and years to come whether the banks will be swept along by the tide created by new competitors, or whether they will be tugged back by the adverse current of regulation.