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Financial
08 June 2010

CEPS report on Europe 2020: A Promising Strategy?


Karel Lannoo argues that the combined effect of global and EU rules will lead to lower profitability for global universal banks and will represent an incentive to re-consider the universal model in favour of a segmentation of the financial system in niches to benefit from the lower capital charges.

Which New Brave New World for Banking?
The combined effect of global, EU and national rules means that regulation will stem even more from the centre in banks’ business models than has been the case so far. It will lead to much lower profitability for global universal banks and will represent a strong incentive to re-consider the universal model in favour of a segmentation of the financial system in niches to benefit from the lower capital charges for specialist players and reduce complexity. This will be accelerated by the possible introduction of a bank tax.
JP Morgan has calculated that the capital needs of global banks would be an additional 19% of tangible equity as a result of the new measures. The profitability of global banks would decline from 13.3% in 2007 to 5.4% in 2011 due to the different proposals now on the table. At these levels, it would be difficult to attract private capital; hence, the pricing of financial products would have to increase substantially, by about 33%.
Rating agents also see a huge need for additional capital in the banking sector. As governments progressively retrieve the guarantees and support schemes, downgrades will follow, leading to additional capital and refinancing needs peaking in 2012.
The question is whether it remains interesting to be a global universal bank under these circumstances. According to the JP Morgan report cited above, scale continues to offer an advantage of serving a larger and more complex client base. Economies of scale emerge from spreading fixed costs over a larger revenue base and lower funding costs. The difference is that in the Basel II framework, capital needs were declining with size or barely existing at all for SPVs and OTC derivatives trading, for example. Now the opposite will be true. The new Basel framework adopts tougher standards for Systemically Important Financial Institutions requiring them to internalise the risks they create for the public at large. It sets higher capital requirements for trading book activities, counterparty credit risk, complex securitisations and re-securitisations, and OTC derivative activities. Normal capital requirement will be allowed for centrally cleared derivatives, but this will require banks to participate in the capital of these CCPs. Before, these banks could propose their own risk models for these activities. As authorities will be extremely wary of having too-big-to-fail banks under their supervision, certainly within the EU as long as fiscal policy remains local, enforcement will be guaranteed.
In addition, the new bank tax that is in the making will tax a certain part of a bank’s liabilities, less the capital, or tax the sum of profits and remuneration in the financial sector. Such a tax would tend to reduce the size of the financial sector, as it would tax above level profits and remuneration. This will again hit the larger banks hardest. Moreover, in the EU this tax will be raised at the local level to fund a national resolution fund, which will disadvantage cross-border banks that have expanded through acquisitions (as most have in the EU).
 


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