Basel III implementations have kept banks busy for over a decade. And while we are on the brink of closing this latest Basel accord with last regulation packages, it is good time to reflect on what impact it has had on the European banking industry and us, the consumers.
The effects of Basel III regulatory reform
Generally, regulation aims to make financial markets and institutions more robust, stable, and less vulnerable for shocks arising from financial and economic stress. This should be reflected in reliability, pricing, and trustworthiness of the services financial institutions offer to their clients. This comes with a cost of adapting institution’s risk management, operations and reporting onto new regulatory framework.
When we assess the evaluations of the Basel III reforms, we notice that they paint a different picture depending on the level of the evaluation. For example, on a regulatory level, BCBS arrives to positive conclusion that globally systemic risks have decreased, and financial system is now “less vulnerable to individual banks’ distress” [1]. Furthermore, the fact that banks’ CET1 ratios and LCR and NSFR metrics have risen should positively contribute to their resilience.
From a wider perspective, and in EU’s context, the impacts are more varied as stated in report commissioned by the European Banking Federation (EBF) [2]. Even though, the report agrees that “banking sector is much better capitalised today” and “less exposed to liquidity risks”, it clearly states Basel III reform has added to the regulatory burden, as well as had a true impact on banking sector’s ability to support the real economy. The latter is especially true in those European countries, in which the funding is heavily bank centric [3]. When we add in the fact, that EU banks face higher capital requirements than their peers in the US, it is quite safe to say, that it is not a “level playing field” across the globe – despite the Basel III. The report finds that about 0,8-1,0 percentage points of the return on equity (RoE) gap (US vs EU banks) can be explained by regulatory-induced cost.
This unevenness is clearly observable in the balance sheet development of European banks: in terms of accounting total assets the global share of European banks decreased significantly from 53,9 % (2011) to 36,8 % (2023) [4]. Similar negative development was seen in the share of Tier 1 capital and of risk-weighted assets. While of course this is not purely caused by the regulation, and surely reflects the Europe’s overall situation with its aging demographic and real economy, still – adding substantial regulatory burden is yet another hinderance for European banks.
In addition to the jurisdictional division of impacts, other one spans in the space of the market segmentation. It seems, that the traditional universal banks are becoming bulk producers, whereas the value creation within financial industry happens elsewhere. Big techs and other Financial Infrastructure & Technology services (FITs) have grown their value by order of magnitude more compared to financial services incumbents [5]. This is also reflected in the market cap of the top 50 public global financial services focused companies. From 2010 to 2020 market cap of FITs have risen from ~3% to ~29% of top 50 total market cap, eating away the value of incumbents – especially banks.
Recent crises – and what regulation can’t do
Recent crises offer a suitable lens to gaze deeper into regulation’s limitations. BCBS’ report on the 2023 banking turmoil [6] discusses for example Credit Suisse’s bailout by UBS, and how the new Basel III liquidity metrics performed during the crisis. For LCR the turmoil “calls into question the scope of risks covered by the LCR […] and the outflows rates currently assumed in the LCR”, which clearly couldn’t capture the risk. And more generally, “the liquidity regulations alone cannot prevent all liquidity runs on banks in an age characterised by easy access to information as well as banking services via various digital tools”.
In the aftermath a well-known financial industry practitioner and writer Moorad Choudhry suitably pointed out that “liquidity risk management is not a new art”, rather it sits at the very core of the modern banking [7]. He suggests that perhaps it would be worthwhile to revisit basic principles to ensure sound risk management. I can’t help but to agree; complex regulatory metrics for liquidity may divert us from the original principles.
Furthermore, in addition to the Credit Suisse’s bailout, many of the other recent crises were caused by problems in the basics, rather than in interpretations of the technical details of the fresh Basel III regulation. Some examples include Banca Monte dei Paschi di Siena’s hidden derivatives contracts 2013 [8, 9], Danske Bank’s money laundering scandal 2017 [10, 11], Silicon Valley Bank’s ALM methodology (reliance to uninsured deposits while investing in securities with longer-term maturities) in 2023 [6], and (at least partially) through contagion effects Signature Bank of New York in 2023 with its “poor management” and “without […] adequate risk management practices and controls” [6]. Worth mentioning that the two latter cases operated mainly under U.S. law, but still provide a sound and well-founded examples in this context.
In the end, no amount of regulation will shield the financial institutions from bad governance, poor risk culture or misconduct.
European market: Consolidation, higher barriers to entry, higher prices for consumers
The 2008 with its global financial crisis was a turning point for a banking industry within EU and eurozone. Number of credit institutions peaked in 2008 reaching 6 570 entities [12]. Since then, there has been a steady and continuous decline in the numbers – finally ending up at 3 926 entities in the end of 2023. That’s a decrease of over 40 % in the period of 15 years. This suggests that banking market is now more consolidated and barriers for market entry are higher. The trend is very much visible in our domestic markets in Finland: the number of mergers remain high as banking groups keep consolidating their ranks.
Second major effect of the 2008 crisis is the dramatic increase of the amount of regulation. While Basel III’s European implementation through Capital Requirements Regulation & Directive (CRR / CRD4) contribute substantially to this, there are many others legal frameworks financial institutions have had to adopt: Bank Recovery and Resolution Directive (BRRD), Payment Service Directive 2 (PSD2) and Anti-Money Laundering Directive (AMLD) to name a few.
It requires extensive and very specific know-how from banks’ employees to tackle this regulatory burden – European Banking Authority’s (EBA) the single rulebook [13] is now considered to be over 15 000 pages long. And even though the subject matter is deep, the expert tasks usually involve daunting repetitive elements no matter how automated regulatory reporting systems are. This is a challenge for recruitment and can easily lead to situations of fragmented knowledge within a bank. Furthermore, if the institution fails in using regulatory data for its business metrics and steering, the evaluation of the efficiency of regulatory compliance becomes burdensome.
Since the amount and variety of credit institutions has decreased, that means less supply for consumers from which to choose from. This has affected the consumer prices in certain segments, and we have seen a steady growth in fees and commissions [14]. From banks point of view this is very well founded and has been even necessary to offset substantial decrease in net interest income (NII) during the zero-interest era. For us consumers this just means higher costs for our everyday banking services.
Ride the megatrends – but stick to the basics
As a long-term context, the global megatrends [15, 16] will impact financial institutions of all shapes and sizes. These need to be considered in the organizations strategic planning to ensure competitiveness and relevance in the coming years. Here, however, I want to emphasize the role of the retail banking business as it is today; a necessary and critical enabler when banks prepare for the future.
For larger retail banks, the key lies in leveraging the existing position in bulk operations: safeguarding the market share by not giving too much in with the pricing, user experience (UX), or specific niches. Undoubtedly, this necessarily includes optimizing capital requirements and driving the price with superior customer information through data and models. This steady core business then allows developing for more high-value services in corporate banking or wealth management – and hopefully contribute to the growth of securitization and financing innovation in Europe [3]. At the same time institutions should seek to remain highly relevant in the digital age by building brand, integrating with services & platforms, and exploring new business areas according to their strategic aim.
For smaller and mid-sized institutions playing to their strengths should be the winning strategy (mind the megatrends, though). These could include for example regional presence, customer satisfaction, specific markets, offerings or channels. However, for these institutions, the basics are even more important. Sticking to them doesn’t mean passivity – or letting go of what market offers for successfully running a financial institution. Rather, it means making sure that the risk appetite is properly reflected in products, operations and most importantly the structure and management of the balance sheet & liquidity.
The development of regulation during the past decade has clearly paved the way for general purpose banks to become utility providers with less capabilities to differentiate or to take deliberate profitable risk [5]. I am of an opinion, that banks should be able to do both. Regulation should not force financial institutions into one-size-fits-all mold by setting unreasonable and, frankly, quite technocratic standards to follow. This hinders their capabilities to renew, innovate and support the real economy. Admittedly though, this is a fine line to thread. These bulk financial services (including taking and maintaining deposits, offering wide payment networks and originating loans) offered to general public should be safe and trustworthy – even when the bank is taking some calculated risk for better return.
Prospering European financial institutions are a common interest for us all. They will benefit both the consumers and the wider real economy. Now that Basel III is coming into closure, it would be good time to let European banks adapt themselves and start developing competitiveness and profitability. Rather than over-regulate them into despair, let’s leave them to flourish and ensure European well-being in the future.
Photo by Kari Koski
References
[1] BCBS (Dec 2022) Evaluation of the impact and efficacy of the Basel III reforms (bis.org)
[2] OliverWyman (Jan 2023) The EU Banking Regulatory Framework and its Impact on Banks and the Economy
[3] Mario Draghi (2024) The future of European competitiveness – In-depth analysis and recommendations
[4] BCBS (Mar 2024), Basel III Monitoring Report
[5] OliverWyman (2023) The State Of The Financial Services Industry 2022
[6] BCBS (Oct 2023) Report on the 2023 banking turmoil
[7] Moorad Choudhry (June 2024, referenced Oct 2024) LinkedIn post
[8] Barron’s (May 2022, referenced Oct 2024) Bankers Acquitted In Italy Over Derivatives Scandal
[9] FT.com (Dec 2023, referenced Oct 2024) Italian court acquits former Monte dei Paschi bosses in derivatives case
[10] FT.com (Dec 2018, referenced Oct 2024) Danske: anatomy of a money laundering scandal
[11] Reuters.com (Dec 2022, referenced Oct 2024) Danske Bank pleads guilty to resolve long-running Estonia money-laundering probe | Reuters
[12] Statista (03/2024). Number of credit institutions in the euro area from 2007 to 2023
[13] EBA (referenced 10/2024) The Single Rulebook | European Banking Authority
[14] FIN-FSA, Financial Supervisory Authority (referenced 10/2024) Key financial figures 2016–2023 – Banks – www.finanssivalvonta.fi
[15] Sitra (2023) Megatrends 2023 update: understanding an era of surprises
[16] Statista (referenced 10/2024) Global megatrends – Statistics & Facts | Statista
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