Fueling the Recovery: The Role of Capital Markets and Banks
Several days after the meeting of the European Central Bank’s (ECB) Governing Council, AICGS gathered a group of American and European panelists to discuss the role of capital markets and banks at AICGS’ Annual Symposium in Germany, held this year in Frankfurt. Below is a summary of the event, with links to several of the written speeches.
Dr. Jackson Janes, President of AICGS, opened the Symposium by saying that the goal was to examine to what extent the European and American financial systems are on a converging or diverging trajectories as both sides continue to emerge out of the crisis. By the end of the day, it was agreed by almost all that the main difference between the two systems is the level of regulation in each economy and the speed in which new and effective regulation is created.
Jeffrey Tessler, Member of the Executive Board at Deutsche Börse, gave an opening speech where he emphasized the need to carefully examine levels of regulation on both sides of the Atlantic. According to him, the financial crisis has exposed some core values that need to be protected such as individual responsibility; integrity and avoidance of excessive exposure; and efficiency and transparency with a need for a more simplified market structure. Finally, the crisis has taught us that we must harmonize the U.S. and EU financial markets, otherwise the door is open to regulatory arbitrage.
Funding the Recovery: The Role of Capital Markets
The banking sector in Europe has witnessed significant structural changes since the financial crisis and the continent is experiencing constraints on credit flows to the real economy, in particular to small and medium-sized enterprises (SMEs). Against this backdrop, the first panel on “Funding the Recovery: The Role of Capital Markets” was introduced by Andreas Povel, General Manager of the American Chamber of Commerce in Germany e.V., who said that the European Investment Bank (EIB) is an integral part of supporting the recovery and committed to unlocking access to finance for SMEs. He then introduced Dr. Werner Hoyer, President of the European Investment Bank (EIB), who showed how the role of institutions like the EIB has grown over the past few years in stimulating the private sector. Overall, the slow speed of the EU’s recovery is attributed to a different financial structure from that in the U.S: bank loans amount to 70 percent of non-financial corporations’ total liabilities in the euro area and less than 20 percent in the U.S. The U.S. economy relies on funding outside of the banking sector.
With slow credit growth in Europe, Dr. Hoyer said that there is a need for political action to increase credit supply and to support European banks’ ability to lend. The main impediments to European economic growth are the quality of banks’ portfolios, access of banks in the periphery to cross-border funding, and a new regulatory environment, which “may affect banks’ ability to offer long-term finance for the private sector.” He believes that the implementation of the Banking Union and the ECB’s Targeted Longer-term Refinancing Operations will strongly contribute to removing the supply side constraints to banks. The single supervisory mechanism (SSM) reduces uncertainty and fulfills the need of a single actor supervising the market.
On the other hand, Benoît Coeuré of the European Central Bank said that perhaps it is too early for cross-border integration in a long-term recovery, and that price convergence is not enough. If we focus on recovery first and integration second, then a stronger emphasis should be made on increasing consumption and providing incentives to lending at both an EU and a national level.
Dr. John Lipsky, former IMF Deputy Managing Director, said that the parameters for banking regulation should be redefined, and there should be a higher quality of supervision with institutions that operate in multiple jurisdictions like a banking union. Stress tests create an immense burden on European financial institutions and inhibit credit growth in the short term while establishing ground rules for more stable and responsive financial systems. They could produce a more diverse and securitized financial system in Europe without copying the U.S. system.
Ralph Brinkhaus, Deputy Chairman of the CDU/CSU Parliamentary Group in the German Bundestag, said that the fear in 2008 and 2009 that the euro would collapse has been generally alleviated, but that we still need further regulation. Beyond increasing regulation, we need to rebalance regulation and make sure that the ECB regains a democratic control. Dr. Federico Arcelli of Oliver Wyman, also said that he is now able to be much more optimistic about the future of Europe. And this environment will encourage investors as the perception changes. Banks should facilitate investments to encourage the flow of capital in Europe, and obtain a stronger basis of credit. This optimism was shared with Dr. Stephan Hutter, Partner at Skadden, Arps, Slate, Meagher & Flom, who said that Europe is moving slowly but surely to more capital market driven finance, and that we are finally seeing increased interest in companies wanting to go public.
The Changing Banking Sector: What Kind of Banks Do We Need?
Responding first to the 2008 financial crisis, U.S. regulators’ introduction of Dodd-Frank helped to stabilize the U.S. financial sector. Roger Blissett of RBC Capital Markets Institute of International Bankers warned that, although this regulation had a profound impact in the early days of the crisis, it has taken a negative turn more recently, forcing foreign financial institutions to restructure under holding companies and adding an additional layer of regulation. This very damaging move on foreign banks will lead U.S. capital markets either toward shadow banking or, hopefully, to U.S. lenders. And, other countries have taken notice, as the United States is a major exporter of financial regulation in the world. This begs the question: what kind of banks do we need?
Meanwhile, Gerhard Hofmann of the Bundesverband der Deutschen Volksbanken heralded the success of small and medium banks. Their track record is impressive. According to Mr. Hofmann, these banks have fewer toxic assets and a good profit-to-loss ratio since 2010. And, not only have they increased lending 4 percent on average since the crisis, but these small lenders have also avoided the credit crunch seen in many other financial institutions.
However, not all panelists agreed with this emphasis on local and regional banks. Warning against lacking regulation among these smaller institutions, Eugene Ludwig of Promontory Financial Group predicted that the increasing regulatory pressure on national and global institutions will naturally lead to growth among in this under-regulated group of banks.
This balance reveals a critical insight: the United States and, especially, Europe need a diverse credit ecosystem. Deutsche Bank’s Stephan Leithner stressed that Europe has a gap in banking at the continental level. Local, regional, national, and global banks all have active players. However, the European level is notably underrepresented.
Similarly, regulation must appropriately address all of these levels. In the United States, we should take Dodd-Frank as a 2,000 page regulatory victory and take the upcoming years to carefully analyze the effectiveness of each of these regulations. So says Martin Blessing of Commerzbank, who questioned whether more liquidity would actually improve the system. Increasing liquidity in our unstable system could backfire and only result in more risky lending.
A multi-level banking system also leads to the problem of “ring-fencing,” which ties back into this panel’s introduction. Banks operate globally but die locally. Without a long-term, stabilizing, global deal, a multitude of short-term, local deals run the risk of turning worldwide financial institutions’ presence into Swiss cheese.
Ultimately, all these measures will require significant further study. But how long can we perpetuate this “construction period?” This question must especially account for the looming banking issues: burgeoning regulatory complexity and a seller beware environment.
Special Presentation: Better Regulated Financial Markets for a Sustainable Economic Development
Although globalization has succeeded in lifting millions out of poverty, it must also be managed. This internationalization has introduced systemic risk into a financial industry that overvalues short-term profits. German Federal Minister of Finance Wolfgang Schäuble argued that these maligned incentives created prolific crises, costing tens of percentage points of nations’ GDPs, and underline the need for better regulated financial markets.
First, we must make crucial improvements to financial regulation. Minister Schäuble remarked, “the Great Recession is to financial markets, as the Great Recession was to the business cycle.” Thus, supervisors must be aware of all significant risks; no industry can be exempt from this regulatory oversight. He emphasized that increased reporting will improve regulators’ ability to address these risks and catch up in any unregulated sectors. Meanwhile, we must restore the links between risk and liability, reward and responsibility. This effort also means targeting behavior, such as high frequency trading, that endangers the whole system.
Second, on the side of the central bank, we must remember that monetary policy cannot solve the fundamental problems of this crisis. The finance minister argued that we should be wary not to extend low interest rates for too long; Europe needs moderate sustainable growth.
Capital markets in the United States and Europe have room to move closer together. However, it is not possible to carbon copy U.S. strategies in Europe. Minister Schäuble argued that attitudes in Europe toward financial risks must similarly evolve to allow increased cooperation. However, we must also remember that what the United States gains in access to capital markets comes at a cost: higher risk. In this sense, both sides of the Atlantic have missed the mark on capital and risk.
For the United States and Europe to fulfill our global financial responsibility, we must cooperate more closely. National regulation is no longer enough in a globalizing world, according to Minister Schäuble. To do this, we must capitalize on each other’s strengths: U.S. hard power and EU soft power. For the United States, this means realizing President Obama’s speech at the U.S. Military Academy at West Point. Ratifying the IMF reforms will be an instance of U.S. exceptionalism by proving international norms through concrete action. Similarly, the minister stressed that we should remain highly optimistic. The Transatlantic Trade and Investment Partnership (TTIP) must succeed.
As integration in Europe continues, it is clear that some member states are more willing than others to cede sovereignty to Brussels. While strengthening democratic institutions, we need to find better, more flexible ways forward. But, most importantly, the UK must not leave the EU; this would be a disaster. Meanwhile on the periphery, Schäuble reminded conference attendees that monetary policy cannot replace structural reforms. The main problem is improving competitiveness, and more specifically, this competitiveness is in comparison to non-EU states.
In closing, Minister Schäuble reiterated that the United States is funded largely by capital markets, and the EU is funded more typically by banks. This trend cannot change in one generation. We must learn from each other and achieve what is possible within our attitudes toward capital and risk.
View the Speeches