Ever since the global financial crisis, social and political debates have placed a spotlight on measures to regulate and stabilise financial markets. In the past ten years, numerous reforms have been made to the way financial markets are regulated. This process was launched at the international level by the G20 and led to the reworking of the Basel regulatory framework for banks. Most of the revised Basel framework has been adopted by the European Union in the form of uniform banking legislation comprised of the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD IV). These reforms have been supplemented by additional national and European measures that aim to regulate financial markets in a way that is reasonable and that is commensurate with the level of risk. The primary focus of these measures is to improve financial stability (see Figure 1).
What is “financial stability”?
“Financial stability” is defined as a condition in which the financial system fulfils its proper functions in the economy, especially at times when unforeseeable circumstances occur, when the economy is under pressure, or when structural transitions are taking place. These functions include the allocation of financial resources and risk as well as the processing of payment transactions. Financial systems must be stable in order to perform their economic functions appropriately and contribute to sustainable growth. Thus the concept of financial stability refers to the financial system as a whole and encompasses more than just the stability of individual entities such as banks and insurers.
As the implementation of reforms progresses, stakeholders – including policy-makers, regulatory and supervisory authorities, and companies – increasingly want to know whether these aims have been achieved. It is also important to know what costs the reforms have generated and whether the measures taken have had unwanted side effects. To this end, during the German G20 presidency in 2017, the G20 countries agreed on a framework for evaluating the effects of financial regulatory reforms. Using this framework as a basis, the Financial Stability Board (FSB) will conduct regular evaluations of financial regulatory reforms. To date, the FSB has carried out two evaluations assessing the overall effects of these reforms.1
G20 framework for evaluating financial regulatory reforms
Since 2015, the FSB has been publishing annual reports on the implementation and effects of internationally agreed financial regulatory reforms. So far, these reports have been based on relatively simple analyses. The G20 framework for evaluating financial regulatory reforms makes it possible for the first time to conduct a structured assessment of the social benefits and costs of reforms. The framework also outlines methods and procedures that can be used to conduct evaluations. This places the framework solidly in the tradition of other policy and research areas where evaluations are already standard practice. The framework was adopted by the G20 heads of state and government in July 2017 and subsequently published.
In Germany, too, there has been increasing pressure to conduct a detailed assessment of how the reforms work, and how effective they are. To this end, the Federal Ministry of Finance asked an independent research institute to carry out a scientific study evaluating the impacts that financial regulatory reforms have had on Germany’s financial sector. The study focuses on the banking sector in particular because it plays such a prominent role in Germany’s finance industry. And because the regulation of the banking sector is harmonised to a great extent at the European level, the analysis concentrates primarily on the effects of European regulatory reforms. Following an EU-wide tender procedure, the SAFE Research Center at the University of Frankfurt (SAFE stands for “Sustainable Architecture for Finance in Europe”) was tasked with conducting the study. The report is posted on SAFE’s website (in German, with an executive summary in English).2
Reforming the regulation of European financial markets
Most experts believe that the global financial crisis was triggered by the collapse of the US real estate market. However, deeper causes were already embedded in the global financial system, especially in the banking sector. For example, over-the-counter derivatives transactions – which are conducted directly between two parties – played a major role in spreading the shock emanating from the US financial system. In many cases, banks ran into financial difficulties due to (a) liquidity shortages resulting from a loss of market confidence and/or (b) heavy losses from their own trading. Some of the affected banks had to be bailed out with government funds in order to avert risks to overall financial stability.
To address these problems, key reforms in recent years have focused in particular on the following priorities:
- Reforms to capital adequacy rules were adopted that aim to strengthen the capacity of banks to absorb losses. To this end, revised European banking regulations now require banks to ensure much higher capital adequacy in both quantitative and qualitative terms. In addition, Pillar 2 provisions – which supervisory authorities can invoke to demand capital add-ons from individual banks – were amended and reinforced. Furthermore, risk weight rules were supplemented with a new indicator, the leverage ratio. The leverage ratio measures a bank’s capital adequacy irrespective of the risk profile of a bank’s overall operations.
- Reforms to liquidity rules were adopted with the aim of preventing liquidity shortages. To this end, two new indicators were introduced. First, the “liquidity coverage ratio” measures the high-quality liquid assets held by a bank that enable it to withstand a period of significant, short-term liquidity stress. Second, the “net stable funding ratio” aims to safeguard a bank’s structural liquidity for the period of one year and, in this way, to reduce dependence on short-term refinancing.
- The Single Resolution Mechanism was established with the aim of protecting taxpayers and safeguarding financial stability in cases where banks run into financial difficulties. The SRM’s guiding principle is that taxpayers should no longer foot the bill for bank losses; instead, such losses should be borne by shareholders and investors. To this end, a comprehensive set of instruments was created to deal effectively with systemically important banks in financial distress.
To limit risk exposure from derivatives transactions, requirements were introduced for certain categories of standardised OTC derivatives deemed to be economically significant. Specifically, such derivatives must be traded on exchanges or electronic trading platforms (trading obligation) and settled with the assistance of a central counterparty (clearing obligation). In cases involving derivatives that are not subject to a clearing obligation, the contracting parties must post mutual collateral to reduce potential losses in periods of financial turbulence.
The Single Resolution Mechanism
is one of the cornerstones of the European banking union. The banking union is based on a common set of rules (called the Single Rulebook) that cover banking supervision, the resolution of banks, and deposit guarantee schemes. Under newly adopted resolution legislation, competent authorities are granted preventive powers (including the obligation to prepare resolution plans) along with specific instruments for the resolution of systemically important banks. The main instrument is a bail-in tool that can be applied to the creditors and shareholders of banks. By holding these investors liable for part of the losses incurred by distressed banks, the bail-in tool is designed to ensure that systemically important banks can be resolved without using public funds. To this end, systemically important banks must demonstrate that they hold a sufficient financial buffer for bail-ins.
Findings of the research report
The research report commissioned by the Finance Ministry focuses on key financial regulatory reforms adopted at the national and European level in the aftermath of the financial crisis. The report finds that these measures have been effective and that the financial system is now considerably more resilient. The authors argue that market discipline has been improved without generating significant costs for the overall economy, although financial institutions did incur costs in certain areas as a result of the reforms. The report recommends that a review be undertaken to see whether these costs could be mitigated without compromising financial stability. The authors assert that more action is needed in other areas in order to further reduce risks on bank balance sheets and to limit the side effects of regulatory measures. In their view, key areas where action needs to be taken include the regulatory treatment of sovereign debt and the ongoing high volume of non-performing loans in certain EU member states.
Capital adequacy rules
The report finds that the EU’s new capital adequacy rules have proven to be highly effective. For example, the new qualitative and quantitative requirements have boosted the resilience of the German banking sector. However, it also finds that these rules have generated side effects. For example, banks have reacted to higher capital requirements by reducing their risk-weighted assets. They have done this not only by cutting back on high-risk transactions but also by curtailing their business lending and retail banking operations, opting instead to increase their short-term investments in sovereign debt. The authors suggest that this shift towards investing in sovereign debt may be partly due to the fact that the regulatory framework gives special treatment to sovereign exposures. Overall, the report finds that this decline in lending by certain banks has so far been offset by the positive economic environment and by the lending activities of other banks that have already fulfilled their capital requirements.
The report asserts that the EU’s reformed liquidity requirements are unlikely to have much of an impact on the stability of Germany’s banking sector, because German banks were already subject to strict liquidity rules under existing national legislation. However, the authors do suggest that the enhanced liquidity requirements will have a positive effect throughout Europe as a whole and are therefore likely to further reduce the level of risk exposure in the European banking sector.
Introduction of a European resolution regime
The report finds that the introduction of a European resolution regime has led to a measurable improvement in the functioning of market mechanisms. The authors argue, for example, that there is now a high level of confidence that banks with low capital adequacy can be wound down successfully. In addition, the report shows that, ever since the resolution regime was put in place, investors have been demanding markedly higher risk premiums from banks. This indicates that market participants no longer assume that governments will step in to cover the costs if a bank runs into financial trouble. However, the report did not find a measurable increase in the risk premiums for “bail-in-able” bonds from large, systemically important banks. In the authors’ view, this makes it particularly important for banks to build up the financial buffers that the European Union agreed on, as these buffers will further enhance confidence that systemically relevant banks can be wound down successfully. The authors also warn against an excessive concentration of risk – in both the private sector and the banking sector – from liabilities eligible for bail-in.
Regulating derivatives trading
According to the report, the global volume of outstanding OTC derivatives contracts – along with the risks that such contracts entail – has declined significantly since the financial crisis. Due in part to the clearing obligation adopted by the EU, the volume of derivatives cleared through central counterparties has increased in recent years for certain categories of products deemed economically significant (such as interest rate derivatives and credit derivatives). In other categories of OTC derivatives, however, very little central clearing is done at this time. The report’s authors argue that, thanks to the posting of collateral, banks are now better protected against default by a contracting party.
Costs and complexity of regulatory measures
According to a recent survey, total regulatory compliance costs for the German banking sector amount to a few billion euros per year. Measured in terms of staff and revenue, these costs are especially burdensome for very small banks (with balance sheet totals under €1bn) and very large banks. The heaviest costs are generated by investment advice requirements (for large banks) and reporting requirements (for very small banks that do not belong to associations of banks). In order to reduce the burdens on small banks, the German government is committed to achieving targeted simplifications for small banks with simple business models as part of the revision of EU banking regulations. In the case of large banks, the higher costs go hand-in-hand with higher systemic risks.
Loan loss provisions for non-performing loans
There is still a high volume of non-performing loans (NPLs) in Europe. The report regards this problem as a key threat to the stability of Europe’s banking sector. For this reason, the authors recommend the adoption of economically reasonable write-offs as a key regulatory adjustment that needs to be made. Against this background, they offer a generally positive assessment of International Financial Reporting Standard 9 (IFRS 9), because the implementation of this standard (which took effect at the start of 2018) enables write-downs to be carried out more quickly. They also assert that, because IFRS 9 is still in the early stages of implementation, it is too early to judge reliably whether it has the potential to intensify the business cycle and might thereby trigger adverse effects. In addition to IFRS 9, the report also endorses NPL-specific measures such as the EU’s plans to adopt prudential backstops for loan loss coverage, citing such steps as important signs of progress.
International Financial Reporting Standard 9 (IFRS 9)
is a new international accounting standard developed by the International Accounting Standards Board (IASB). IFRS 9 took effect in the EU on 1 January 2018. The standard contains amended rules for the classification and measurement of financial assets along with a new risk management model that provides for the inclusion of expected losses in the calculation of loan loss provisions.
Transparency and harmonisation
The report also commends the EU’s revised Markets in Financial Instruments Directive (MiFID II) as an important and effective step in advancing European financial market integration and improving supervisory transparency and control. However, it also argues that the initial implementation of the directive involves high costs that could have an influence on business models and on market entry opportunities.
Impact on the aggregate economy
The report finds that financial stability has been greatly reinforced by the reforms that have been implemented. It also states that the reforms have not had a measurably adverse impact on the overall economy. The authors find no indications that the build-up of additional capital has led to a reduction in lending or to substantially higher lending costs. They assert that the loss absorption capacity of the German banking sector has improved significantly overall and that the likelihood of extreme losses has declined. The report also looked at various crisis scenarios to simulate losses that might overwhelm the banking system. Depending on the respective scenario, these projected losses have declined significantly in recent years or even fallen to zero as a result of the adopted reforms.
Financial market regulation: the way forward
The report shows that the implemented reforms have played a key role in enhancing financial stability. The authors recommend further action in certain areas in order to reduce the costs and complexity of regulatory measures and to curb unwanted side effects. At the same time, they call for further risk reduction measures at the European and international level. For this reason, the Federal Ministry of Finance will actively support the implementation of the following measures:
- Improved and updated reporting systems: In addition to advocating specific simplifications, the Federal Ministry of Finance, the Deutsche Bundesbank and the Federal Financial Supervisory Authority (BaFin) intend to support initiatives that are targeted towards the adoption of up-to-date, harmonised yet flexible reporting systems. This would include measures at both the national and European level.
- Improving the proportionality of regulatory measures: During the ongoing revision of European banking regulations, the German government has called for rules to be designed reasonably and in a way that is proportionate to a bank’s size and business model. In addition, the Federal Ministry of Finance will lend its support to the more far-reaching proposal to establish what is referred to as a “Small Banking Box” (in a nutshell: regulatory rules tailored to bank size and business model, with the aim of reducing complexity). In the area of insurance regulation, the Finance Ministry is committed to ensuring that the revision of European insurance regulations includes simplifications for small, low-risk insurance companies.
- Review of transparency rules: The Finance Ministry will team up with the Federal Ministry of Justice and Consumer Protection to review existing financial consumer protection rules. To do this, they will gather information on supervisory practices and analyse the extent to which information requirements benefit investors. If their findings suggest that the rules should be adjusted, the German government will call for necessary amendments to be made to European legislation. In addition, the Finance Ministry will implement the rules contained in the EU’s banking package, especially the rules that are designed to protect small investors from potential bail-in losses.
- Targeted regulatory improvements for funds: In the area of investment funds, the Finance Ministry favours simplifications in the use of durable media for information requirements (digital rather than paper, lower costs for investors). In addition, the Finance Ministry advocates the removal of practical obstacles and the adoption of a more attractive regulatory framework for microfinance funds. Furthermore, it favours an expanded toolbox for the internal liquidity management of funds. Among other things, these measures would reduce risks that could have systemic effects.
- Additional risk reduction measures: The German government has supported and implemented measures at various levels to put reasonable regulations in place and to advance risk reduction. At the national level, for example, the Federal Financial Supervisory Authority was granted new powers that will help to reduce potential risks emanating from the residential property market. These powers, which were enacted in 2017, will be evaluated in 2019. At the European and international level, the German government advocates two top priorities as part of a comprehensive risk reduction agenda: The first is a sustained reduction in the high volume of non-performing loans. In addition, regulatory measures should be put in place that will prevent the excessive build-up of NPLs in the future. To this end, EU finance ministers have adopted an action plan that is in the process of being implemented. Second, the report commissioned by the Finance Ministry recommends further action to improve the resolvability of systemically important large banks. Picking up on this recommendation, the German government calls for the resolute build-up of financial buffers for bail-ins (as agreed upon at the European level), because these financial buffers will enhance the credibility of the resolution regime.
The “small banking box”
classifies banks according to three groups. Regulatory requirements would be gradated according to a bank’s classification, with a simplified supervisory regime for small banks with low-risk business models.