European banking regulation: treat the cause, not the symptoms

by Olivier Colin, 11 September 2014

Remember Nassim Nicholas Taleb’s turkey story? A butcher feeds a turkey on a day-to-day basis in order to eat it at Christmas. By repeating this behaviour, the butcher confirms to the turkey the statement that he will continue to feed it every day, as predicted by the previous days, bringing more confidence every day to that belief. But one knows however that the situation is not to last and one day, there will be a surprise for the turkey…

The famous author of the Black Swan tries to explain that lots of beliefs are built on past behaviour, without even reconsidering them as being wrong. The world of banking is full of statements, concepts and beliefs taken for granted. However, only few of them have been reconsidered after the crisis. In line with the past, a crisis period is always followed by increased regulatory constraints. Despite recent changes in European Regulation as a response to concerns raised by the banking crisis, the new regulatory framework introduced by Basel III and the Banking Union are unfortunately only part of the answer.

www.cliffkule.com

Source: cliffkule.com

Excessive leverage ratio in banking has been highlighted as a crucial factor in the development of the crisis. While banks used to operate with high level of equity (near to 50%) in the 19th century, this percentage has consistently decreased to an average level of roughly 5%. Despite the well-known and recognized risk associated to excessive leverage, banks continue to operate with extremely high leverage level, sometimes even higher than before the crisis. It seems that nothing has been learned from the past. European banks, largely exposed to EU countries domestic debt, are even more concerned by the issue. This exposure to domestic debt leads them in the middle of a snowball effect, banks being affected by sovereign debt volatility, and debt being affected by bank instability. European regulations such as the last Capital Requirement Directive (CRDIV) are actually even increasing this issue by giving incentive to banks to hold more sovereign debt, considered to be safe. This as a whole leads to more interconnection and an increased systemic risk. Until now regulators have mainly concentrated their efforts on improving financial stability by imposing banks to hold a certain level of equity, or by limiting the leverage ratio to a certain level. Without going into details or discussing what should be the exact level of equity or leverage ratio, one must understand that the focus of regulation has always been on the symptoms, and not the real cause of the problems.The time has now come for EU regulators to address the appropriate question: why banks use leverage much more than other companies? Looking at the root cause of the problem, instead of trying to act on the symptom, could contribute in stopping the bank disease and make the financial sector safer. In reality, we can identify three main reasons why bankers prefer debt. The first one, maybe the most obvious, is linked to the remuneration scheme of bank managers. They are widely related to Return On Equity (ROE) related performance indicators. Those indicators are not only incentivising manager’s behaviour towards low equity level, but they are also extremely inappropriate indicators to predict a bank crisis. In a few words, the issue is simple: a wrong performance indicator, that did not enable to predict the crisis, and leading to wrong financing decisions. Bankers should avoid this blindness and ROE obsession, and resort to a variety of indicators, related to added value and value creation.

The second reason, maybe less obvious, is the existence of a debt-equity tax bias. Companies and banks can deduct interests on debt financing, whereas they cannot do it with equity financing. Consequently, you have de facto an incentive to raise more debt, and this without any rational economic reason. This fiscal treatment of debt makes debt financing more attractive than equity financing and should therefore be eliminated, at least for the banking sector. This could be done either by allowing the deductibility of a fictive interest on equity, a system called Allowance for Corporate Equity, similar to the system of “Notional Interests” applied in Belgium, either by preventing the deductibility of interests on debt, a system similar to a Comprehensive Business Income Tax, but difficult to apply in practise. Another alternative would be to combine both systems and give an advantage to equity financing, obviously less risky for the banks.

Last but not least, the famous so-called “too big to fail” implicit guarantee for bank debt minimizes the high risk associated to debt issuing for bank managers and leads to inappropriate behaviours by bank managers. There are different perspectives to tackle this issue. The universal banking model has been discussed for a long time now and since the second bank directive in 1989, European banks are allowed to conduct commercial and investment activities within the same entity. Despite weak and unilateral national reforms such as the banking reform in France, nothing has been done at the European level to solve this issue. Another approach would be to raise a new tax on banks at the European level, to compensate for this “too big to fail” guarantee.

Current regulation consistently focused on imposing some kind of behaviour without even looking at the incentives that leads banks to adopt that behaviour are certainly likely to be irrelevant, if not counterproductive. By drawing huge and complex regulations, regulators are more likely to contribute to the development of regulatory arbitrage inside the banks that tries to deviate from the regulation by complex asset redefinition and other mechanisms. As it is argued that Basel II rules have actually contributed to the development of the shadow banking system, we could wonder what kind of complex mechanism banks are going to develop to get around Basel III.

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