The specter of Brexit; a sea change in administration in the world’s largest economy; the on-going legacy of the “Great Crisis” of 2008; times have never been more prone to uncertainty for the banking sector.
To buffer banking from systemic risk, a raft of regulatory reforms has been mandated over recent years that impose tough increases in capital reserves and greater financial disclosure.
From the Basel Accord of 1988 to the prospect of a “Basel IV,” banks and bankers have been held to public account more stringently than at any other time in the last half-century.
But have these regulations brought with them unpredicted problems or vulnerabilities for the financial sector? Could renewed focus on stability and solvency actually be stifling financial innovation?
And what does good governance and management look like in an environment where public trust in the sector remains at all-time lows?
To address these critical issues, heads of European banks, policy-makers, regulators and leading academics met at the British Medical Association House in London on November 17.
Jointly hosted by IESE and the Columbia School for International and Public Affairs, the third “Challenges for the Future of Banking” conference offered these experts an opportunity to explore and debate the big questions in an intimate environment of open dialogue, conducted under Chatham House Rules.
Attendees included: Jaime Caruana, general manager of the Bank for International Settlements; José Manuel Gonzalez-Páramo, executive board member and director of global economics, regulation & public affairs, BBVA; Paco Ybarra, global head of markets and securities services at Citi; John Vickers, professor of Economics at Oxford University, and John C. Coffee, Adolf A. Berle professor of Law at Columbia Law School.
The keynote speaker was the Rt. Hon George Osborne CH, MP, former chancellor of the Exchequer, Government of the United Kingdom.
Since the crash of 2008, banks have undergone an ambitious reform agenda to make them more resilient to systemic risk.
We have seen a move towards not only more, but better, capital reserves and wholesale deleveraging across the sector.
Yet, despite improvements in capital, with many banks maintaining reserves significantly higher than the 4.5% regulatory minimum, the path to recovering trust remains difficult.
Skepticism from bank equity investors is being reflected in historically low book-to-price ratios and the high internal price of balance sheet capacity; and there are a number of so-called ‘market anomalies’ that bear deeper analysis.
Our first speaker cited constraints in banks’ lending capacity, despite higher capital reserves, as a function not only of regulatory issues, but also of certain market pressures. Fears of downgrades, he argued, were generating uncertainty and leading to conservative behaviors.
While regulation was certainly important in this, it was by no means the only factor. The issue of high dividend payouts to shareholders – a contentious topic – was singled out as significant constraint to bank profitability in the longer-term.
On top of this, low interest rates coupled with generalized uncertainty about the underlying economy – especially in the Eurozone – were seen to persistently negatively affect bank stock prices.
Key to understanding and addressing these issues from a regulatory standpoint, it was agreed, was a need to broaden the data that regulators look at and include more behavioral analysis.
That said, the panel was unanimous about the “good work” being done across the sector in terms of cost-cutting, de-risking and simplification of governance.
In a “well-functioning market” competitive forces lead to innovations that provide customers with what they really want.
Dynamic rivalry between organizations fuels inventiveness and generates few or not negative externalities on third parties. Customers make well-informed choices.
This is not the case in finance, argued our second speaker, because of intrinsic difficulties in creating a well-functioning financial market.
Poor incentives, banks’ on-going proneness to maximize leverage due to the cost of equity capital, downward share price spirals and high dividend payouts – all of these factors are fueling a kind of innovation, he said, that does not favor broader societal goals.
The real question should not be whether there is a trade-off between regulation and innovation; the question is whether innovation in banking is taking the right direction.
In the pre-crisis scenario banking was characterized by securitization to drive leverage and sector-wide miss-selling issues. While many of the problems had been addressed by regulation, our speaker felt that policy still fell short, and that “exploitation” of unsophisticated customers was deterring the right kind of innovation and distorting healthy competition.
Banks were urged to do much more in terms of pursuing a collective good. This meant attaining the right levels of capital (in spite of negative outlooks and the threat of Brexit leading to a “Balkanization” of the Eurozone). It also meant addressing controversial compensation issues, and reviewing financial intermediation so that costs are not passed to customers.
Before 2008, around 80% of the conversation in banking was around growth strategy.
Post-crisis, a good deal has changed, with risk rather than strategy now topping the agenda.
Our final two panels of academics, board directors and senior bankers explored the challenges facing institutions in these times of flux – with digital changing the playing field, but also generating unprecedented hacking risks; and the potential for deregulation as a legacy of the Trump presidency.
In this context, it was noted that the European Central Bank had stepped up measures to drive a shift from effectiveness in bank leadership to compliance – a move that was interpreted by some as potential intervention in the structure of boards.
A range of dimensions came under the spotlight: from the “dangerous tenet” of shareholder activism, and the “quantum and credibility” of capital, to the building of culture and the hiring and incentivizing of the right people in the right jobs.
In an environment characterized by enormous information flows and the fear of constant recalibration within the regulatory machine, it was largely agreed that bank leadership should focus on creating effective mechanisms for non-siloed conversations to take place.
This included collective response to hacking threats to protect the entire system.
While tone at the top was seen as critical, it was felt by all that tone and actions needed to be reinforced over a systematic period of time.
A number of key recommendations made by our final speaker were universally well received. These included:
The banking sector, it was felt by both panels, is at an existential moment faced by the multiple challenges of recession, low return, regulation, reputation and the digital revolution.
And while an immense amount of work has been done in the last eight years, there is still much more to be done.