BBVA Research - What impact is regulation having …...(EC < BBVA < IIF) Consumption -0.12 -0.15 -0.50 GDP -0.40 -0.59 -1.22 Variable Year 1 Year 4 Long-run Some indirect eﬀects

What impact is regulation having on the European financial services sector? Rafael Doménech and Santiago Fernández de Lis

Wilton Park Conference: Financial Regulation in the European Union: The Impact on The Economy and The Financial Services Sector

Frankfurt, March 19-21, 2012

Regulation and the European Financial Sector, March 2012

Page 2

Main messages

Supply side: effects of higher capital

requirements

Demand side: effects of lower credit/GDP

European financial integration

Procyclical banking regulation

Frontloading of Basel III: greater negative effect in credit than in GDP → acceleration of deleveraging

Negative short-run effects on ROE and ROA, with very high heterogeneity across countries (e#iciency, competition, ... )

More European integration needed, but fragmented financial markets point in the opposite direction

Regulatory overreaction to the financial crisis: race to the top, too soon

Effects Drivers


Page 3

1. Impact of European banks recapitalization

Production sector

Banking sector

Patient households

Impatient households

Banks

Central Bank

Retail

Wholesale

Deposits

Loans

Loans

Financial shocks Macroeconomic shocks

Monetary shock

Households

Public sector

DSGE model for EMU

Entrepreneurs

Retail sector Capital goods Labour market


Page 4

Credit -1.78 -2.39 -5.03

Investment -2.34 -3.86 -6.86

1. Impact of European banks recapitalization

The GDP fall to meet the EBA requirements would be -0.2pp in the first year

Impact of Basel III + EBA + 1% Banks’ decision (EC < BBVA < IIF)

Consumption -0.12 -0.15 -0.50

GDP -0.40 -0.59 -1.22

Variable Year 1 Year 4 Long-run

Some indirect effects and recapitalization strategies may reduce these negative effects


Page 5

2. Effects of lower credit demand on the banking sector

Banking output over GDP

Employment

Short-term effects on profitability

ROE and ROA

In general credit expansion implied an increase of VA/GDP Deleveraging → lower GDP share but with great heterogeneity

Employment share shows higher relative productivity of banks Deleveraging and technical progress will accelerate this process

Deleveraging will have negative transitory effects on ROA and ROE

No relationship between leverage and ROA & ROE in the long run Large heterogeneity across countries: e#iciency and competition

Effects Dimensions


Page 6

-‐500

0

500

1,000

1,500

2,000

2,500

3,000

3,500

Feb-‐93

Feb-‐94

Feb-‐95

Feb-‐96

Feb-‐97

Feb-‐98

Feb-‐99

Feb-‐00

Feb-‐01

Feb-‐02

Feb-‐03

Feb-‐04

Feb-‐05

Feb-‐06

Feb-‐07

Feb-‐08

Feb-‐09

Feb-‐10

Feb-‐11

Feb-‐12

IRELAND SPAIN ITALY PORTUGAL GREECE

Partly a result of asymmetric market discipline … … partly a result of regulation

Risk-off Risk-off Risk-on

3. Pro-cyclicality of the financial system

Sovereing 10Y spread Source: BBVA Research based on Bloomberg data

Spain: Equity to assets and output gap Source: BBVA Research based on Bloomberg data

0 .0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

-‐4.0%

-‐3.0%

-‐2.0%

-‐1.0%

0 .0%

1.0%

2.0%

3.0%

4.0%

5.0%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Output gap in percent of potential GDP Equity to assets (right)


Page 7

3. Regulatory responses to the global crisis

Core Capital Ratio* (%) *Core capital + Conservation Buffer Source: BBVA Research based BIS data

In the good times: regulatory arbitrage led to a “race to the bottom” in regulation

In the bad times, “race to the top” (partly as a result of market pressure), overriding Basel III

gradualism

EBA exercise exacerbates pro-cyclicality and opens the Pandora’s box of credit risk in own

sovereign exposure 0%

2%

4%

6%

8%

10%

12%

EBA 2012

RetailUK 2019

Inve

stmen

t UK

2019

Switzerlan

d 20

19

Spain 20

11

Swed

en

Austria

Greece 20

12

New

Zea

land

2013

Brazil 20

13-‐2014

New

Zea

land

2013

Brazil

Méx

ico 20

12

India 20

17

Basel III 2019

Basel III 2015


Page 8

Is this crisis the start of a reversal in financial globalization?

Ring fencing

Capital controls (Capital Flow Management

Measures) Markets segmentation

Uneven implementation of regulatory reform

EU: A risk for the Single Market

4. The segmentation of financial markets


Page 9

4. The crisis endangers financial integration in Europe

•  Reversal of financial integration in the Eurozone –  Lack of transparency in banks BS, despite stress tests –  … and exacerbated perception of country risk –  Circularity sovereign and banking risk

* European Commission (2011), “European Financial Stability and Integration Report 2010” and ECB (2011), ”Financial Integration in Europe”

Geographical counterparty breakdown in EMU unsecured money markets (%) Source: European Commission

Collateral used for Eurosystem credit operations (%) Source: ECB

20

25

30

35

40

45

50

55

60

2006 2007 2008 2009 2010 2011

Domestic EMU Other

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Domestic Cross border


Page 10


Financial activity in general is becoming more national

European banks: number of sales of foreign an domestic units Source: ECB and Bankscope Zephyr

European banks’ average exposure to EU members (USD) Source: BIS

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010

Domestic Foreign

0

100 ,000

200 ,000

300 ,000

400 ,000

500 ,000

600 ,000

700 ,000

800 ,000

Dec.2005

Mar.2006

Jun.20

06

Sep.20

06

Dec.2006

Mar.2007

Jun.20

07

Sep.20

07

Dec.2007

Mar.2008

Jun.20

08

Sep.20

08

Dec.2008

Mar.2009

Jun.20

09

Sep.20

09

Dec.2009

Mar.2010

Jun.20

10Se

p.20

10Dec.2010

Mar.2011

Jun.20

11Se

p.20

11

Core twoards Core Core towards PeripheralCore towards CEE Peripheral towards Peripheral


Page 11


•  Reversal is more pronounced in short-term, more integrated segments …

•  … whereas less integrated, longer term segments (equity) are less affected

•  At the same time, banking concentration is increasing in Europe

Cross-border provision of !inancial sevices in the euro area-assets (%) Source: ECB

Share of toal assets by !ive largest credit institutions Source: BBVA Research based on ECB data

0

10

20

30

40

50

60

2006 2007 2008 2009 2010

Non-‐bank securities other than shares Interbank loansLoans to non-‐banks Non-‐bank shares and other equity

20

30

40

50

60

70

80

Ger

man

y

Irela

nd

Gre

ece

Spai

n

Fran

ce

Italy

Portu

gal

Uni

ted

King

dom

2007 2010


Page 12

4. Restoring European financial markets

Regulatory pressure + segmentation + concentration = risk of e#icieny losses, widening of intermediation costs

Important to resume the trend towards financial integration in Europe

The ECB liquidity injection provides a valuable breathing space …

… but the euro zone banking system cannot rely indefinitely on the ECB intermediation function

It is imperative to restore the normal functioning of interbank and wholesale markets


Page 13

Main messages

Supply side: effects of higher capital

requirements

Demand side: effects of lower credit/GDP

European financial integration

Procyclical banking regulation

Frontloading of Basel III: greater negative effect in credit than in GDP → acceleration of deleveraging

Negative short-run effects on ROE and ROA, with very high heterogeneity across countries (e#iciency, competition, ... )

More European integration needed, but fragmented financial markets point in the opposite direction

Regulatory overreaction to the financial crisis: race to the top, too soon

Effects Drivers

Thank you

www.bbvaresearch.com

Annex: What impact is regulation having on the European financial services sector? Rafael Doménech and Santiago Fernández de Lis

Wilton Park Conference: Financial Regulation in the European Union: The Impact on The Economy and The Financial Services Sector

Frankfurt, March 19-21, 2012


Page 16

Annex Leverage and banking performance

Regressions of output, employment and returns on credit over GDP

Dependent variablesVAB L ROA ROE ROA ROE

Credit/GDP 0.03 -0.01 -0.004 -0.089(4.59) (2.40) (2.44) (2.62)

Credit/GDP 0.048 0.987(First di!ference) (8.75) (7.91)

N. Obs. 94 94 101 102 93 94R sq. 0.19 0.06 0.06 0.06 0.46 0.40Period: 1998"2011. Countries: Spain, Germany, France, UK, Belgium, Netherlands, Ireland and Italy

Although econometric results are statiscally significant, they hide too much heterogeneity and patterns across countries


Page 17

Annex

Deleveraging and baking output in National Accounts

Credit/GDP and VA of banking sector over GDP Source:

In general, credit expansion has implied an increase of banking output over GDP

Nevertheless there is a clear heterogeneity across countries

Deleveraging will imply a lower GDP contribution of the banking sector

Spain has been clearly an exception to this pattern


Page 18

Annex

Deleveraging and banking employment

Credit/GDP and banking employment share Source:

Despite the increase in GDP share, employment share has fallen or remained constant …

… due to the increase in the relative productivity of the banking sector

Deleveraging and technical progress will accelerate this process


Page 19

Annex

Deleveraging and banking profitability

ROA and Credit/GDP Cross-section and time series evidence Source:

No clear relationship between credit/GDP and ROA

Long-run levels of ROA determined by other factors as e#iciency or competition

Similar results are obtained in terms of ROE


Page 20

Annex


ROE and ROA Cross-section and time series evidence Source:

Countries with similar ROE show very different ROA and, therefore, different K/A

Countries with similar K/A show very different combinations of ROA and ROE

Higher K/A does not imply lower ROE in the long run


Page 21

Annex


ROA and Credit/GDP Cross-section and time series evidence Source:

Transitory positive correlation between the changes in credit/GDP and ROA

Deleveraging will have negative transitory effects on ROA

Similar results are obtained in terms of ROE


Page 22

Annex


Equity markets and Credit/GDP Banks index relative to total (Dec 31, 1999=100). Source: Euro Stoxx

50#

60#

70#

80#

90#

100#

110#

120#

130#

31/12/99#

05/07/00#

08/01/01#

12/07/01#

15/01/02#

19/07/02#

22/01/03#

28/07/03#

29/01/04#

03/08/04#

04/02/05#

10/08/05#

13/02/06#

17/08/06#

20/02/07#

24/08/07#

27/02/08#

01/09/08#

05/03/09#

08/09/09#

12/03/10#

15/09/10#

21/03/11#

22/09/11#

Periods of high growth in credit and profits → Better relative performance of banks

Expectations of losses and credit deleveraging → Worse relative performance of banks

Long-term performance determined by other factors, leverage not the most relevant

Documents

BBVA Research - What impact is regulation having …...(EC < BBVA < IIF) Consumption -0.12 -0.15 -0.50 GDP -0.40 -0.59 -1.22 Variable Year 1 Year 4 Long-run Some indirect eﬀects