1. How will regulation reshape the banking system? Yasmine de Bray 11/05/2012

2. How will new regulation reshape the banking system? - 08/05/2015 - page 2 Summary 01 New regulation is putting pressure on the size of the banking system… 02 …but the risk of an abrupt shrinkage has more to do with the current sovereign crisis 03 Regulation should be instrumental in avoiding future liquidity crisis but should not overshoot

3. How will new regulation reshape the banking system? - 08/05/2015 - page 3 1/ New regulation is putting pressure on the size of the banking system Regulators require banks to hold more capital –The switch from Basel 2 to Basel 3 is reducing the average common equity ratio of the top 100 global banks by 3% points from 10.2% at June-end 2012 to 7.1% as per the latest QIS published by the Basel Committee on April 12th. –In practice, European regulators are requesting their domestic banks to hold common equity ratios of at least 9%. More than €500bn has been raised so far in Europe: 55% of which has been provided by governments and 45% by private investors. European banks’ core tier 1 ratios have improved from 6.5% in 2008 to 10% in 2011. Ability to raise further capital is limited given governments’ over-indebtedness and the lack of investors’ appetite for bank stocks due to poor risk-adjusted returns (cf Unicredit’s difficult capital increase in early January which required a 40% discount to TERP). The other way for banks to release capital is to reduce their balance sheets… Source: Goldman Sachs

4. How will new regulation reshape the banking system? - 08/05/2015 - page 4 1/ New regulation is putting pressure on the size of the banking system Regulation is to structurally reduce the size of the senior debt market: –The European commission recently issued a consultation paper suggesting that regulators should be able to impose losses on bank creditors before the bank become insolvent potentially based on a trigger mechanism. The key is whether it will be a low or high trigger. –Term senior unsecured debt would become more “capital” than “funding” in nature, and would become more expensive. This could lead to a structural reduction in banks’ unsecured debt funding reliance, only partially offset by growing covered bond issuance. Regulation is likely to reduce the velocity of money –Growing scrutiny on re-hypothecation. –Higher risk weights for credit exposure to large regulated banks (>100bn asset). We estimate the total deleveraging effort to be close to €1.3 trillion of assets (5.7% of total assets) over the next 3 years for European listed banks, which could release €50bn of capital. –Under the IMF base-case scenario for a sample of 58 large EU banks, the reduction of bank assets would be €1.6bn over the next two years, €2.5bn under their worst-case scenario. This should help close an estimated capital shortfall of around €80bn in Europe and help manage down the stock of senior debt funding (€730bn maturities in 2012-2014). Source: Amundi, Morgan Stanley

5. How will new regulation reshape the banking system? - 08/05/2015 - page 5 2/ New regulation is putting pressure on the size of CIB activities The deleveraging effort is focusing on corporate and investment banking –European banks announced risk-weighted asset reduction plans of €700bn since 2009 in their CIB business, 37% of which has been completed so far. –35% of the remaining deleveraging efforts will focus on CIB activities. –CIB activities can be downsized faster. –CIB is very competitive and will become less profitable under Basel 3 (CVA, greater capital requirement for market risks etc..). –Example of explicit regulatory/political pressure: RBS requested to specifically downsize its investment bank. Regulation will lead to a polarisation in the investment banking industry –Scale will be a competitive advantage given the sector’s high operational leverage (elevated fixed cost base) –Heavy technological investments will be required, with the FICC business likely to move to electronic platform trading business.

6. How will new regulation reshape the banking system? - 08/05/2015 - page 6 3/ New regulation is putting pressure on cross-border lending Regulators are increasingly requesting liquidity to be ring-fenced –The UK independent commission for banking (“ICB”) is requesting the UK ring-fenced entity to be subject to minimum liquidity ratios on its own –The Austrian regulator recommended that Austrian banks’ foreign subsidiaries do not issue new loans in excess of 110% of available local funding. –Hungary, Romania and Bulgaria particularly at risk. Foreign subsidiaries’ compliance with the Basel 3 NSFR will also put pressure on intra-group funding and lending growth given the yet limited size of local debt capital markets. Basel 3 creates a capital shortage: banks will seek to better optimize capital utilization by favouring multiproduct relationships over lending-only relationships, which tend to favour domestic clients. –Banks will however not stop funding their core clients’ off-shore projects. CEE countries will be most impacted… Reduction in credit supply by European banks under the three IMF deleveraging scenarios (in % of total bank credit)

7. How will new regulation reshape the banking system? - 08/05/2015 - page 7 Banks will favour short-term lending over long-term lending to meet Basel 3 liquidity ratio. Banks will seek to gain large corporate (investment-grade) exposures through corporate bonds rather than lending. 4/ Basel 3 will reduce the amount of stable funding to the economy Corporate balance sheets might be weakened (reduced availability of long-term funding for SMEs and greater reliance on volatile market funding for large corporates). This is already visible in the ECB banking surveys: “Some further tightening is expected to affect large firms (8%) rather than SMEs (2%), as well as primarily long-term loans”, April 2012. Sources of corporate debt

8. How will new regulation reshape the banking system? - 08/05/2015 - page 8 Smaller investment banking and international, activities, together with growing disintermediation for corporate funding will help reduce the size of the European banking system… Domestic credit will also be impacted Banking system assets as a % of GDPLoan to deposit ratios by region Source: Barclays

9. How will new regulation reshape the banking system? - 08/05/2015 - page 9 But closing the customer gap will still be needed through: 1.Re-intermediation of off-balance sheet assets, although this could be partially crowed out by State borrowing –Italian banks selling their own retail bonds and term deposits instead of third-party bonds. Introduction of a more favorable fiscal regime for government bonds vs. other savings products. –French banks trying to repatriate savings on balance-sheets: 2.And real lending deleveraging efforts : –Key risk to growth is tightening conditions for investment loans. Domestic credit will also be impacted Source: OEE Dotted lines show the IMF’s three deleveraging scenarios

10. How will new regulation reshape the banking system? - 08/05/2015 - page 10 2.And real lending deleveraging efforts : –Key risk to growth is tightening conditions for investment loans. Domestic credit will also be impacted Source: IMF Dotted lines show the IMF’s three deleveraging scenarios

11. How will new regulation reshape the banking system? - 08/05/2015 - page 11 Summary 01 New regulation is putting pressure on the size of the banking system… 02 …but the risk of an abrupt shrinkage has more to do with the current sovereign crisis 03 Regulation should be instrumental in avoiding future liquidity crisis but should not overshoot

12. How will new regulation reshape the banking system? - 08/05/2015 - page 12 The current risk of credit crunch has more to do with the current crisis. But what is at stake is the risk of an abrupt credit crunch Net % of banks contributing to tightening their credit standards, ECB Credit standards have tightened in H1 2012 with the worsening of the sovereign crisis. Recent relief in Q1 is due the easing of banks and governments’ funding access in the wake of the two LTROs (Dec and Feb).

13. How will new regulation reshape the banking system? - 08/05/2015 - page 13 Credit tightening has more to do with sovereign-related liquidity and capital issues rather than regulations. –Credit conditions for corporates: a net 87.5% of Italian banks reported tighter standards in Q4 vs 35% of European banks in the Q4 2011 ECB survey (25% vs. 9% respectively in the Q1 2012 survey) –Credit conditions for households: a net 87.5% of Italian banks reported tighter standards in Q4 vs 29% of European banks in the Q4 2011 ECB survey (37.5% vs. 17% respectively in the Q1 2012 survey) But what is at stake is the risk of an abrupt credit crunch Difficult wholesale funding access based on sovereign riskCapital shortfall driven by net unrealized losses on bonds As at end of April 2012

14. How will new regulation reshape the banking system? - 08/05/2015 - page 14 …driven by market forces and a previous lack of regulation Banks’ market funding costs were extrememly low…Total market funding issued by European banks p.a. … creating a strong incentive for banks to leverage their balance sheets. Source: ECB

15. How will new regulation reshape the banking system? - 08/05/2015 - page 15 Authorities are seeking to avoid a severe credit crunch: –In Dec 2011 and Feb 2012 the ECB provided €530bn of net additional funding to European banks (LTROs take up less MRO transfers), equivalent to the amount of senior and covered bonds maturing over the next 12 months. –Spanish and Italian banks have covered their 2012 maturities and invested in short-term government bonds. Monetary authorities are trying to smooth the process ECB lending to commercial banks

16. How will new regulation reshape the banking system? - 08/05/2015 - page 16 Summary 01 New regulation is putting pressure on the size of the banking system… 02 …but the risk of an abrupt shrinkage has more to do with the current sovereign crisis 03 Regulation should be instrumental in avoiding future liquidity crisis but should not overshoot

17. How will new regulation reshape the banking system? - 08/05/2015 - page 17 A survey of the Basel Committee on Banking Supervision (BSBC) estimates that the net present value costs to output from financial crises range between 19% and 163% of annual GDP (with a median estimate of 63%). The same survey estimates that financial crises occur approximately every twenty to twenty-five years. So financial crisis would cost 3% of GDP per year. According to a BIS paper published in 2010, the probability of systemic banking crisis is substantially reduced for systems’ core tier 1 in excess of 9%. The relationship between bank lending growth and GDP growth, although intuitively positive, is not straightforward –1980s: the introduction of credit cards did not lead to stellar GDP growth –Past periods of deleveraging show varying outcome for underlying economic growth. –Credit crunch induced by banking crises negatively impact investments. The cost of financial crises might outweigh that of regulation

18. How will new regulation reshape the banking system? - 08/05/2015 - page 18 Shadow banking is defined as “the system of credit intermediation that involves entities and activities outside the regular banking system“ as per the FSB): insurance companies, asset managers, hedge funds, pension funds, non-regulated credit institutions…” –Non-rated private securitization placements (with more flexible collateral eligibility criteria) –Loans Liquidity and credit risks are being transferred to “unregulated” institutions. When regulated, regulation plays against this transfer (cf Insurance). Non-regulated shadow banking entities could pose systemic risk if connected to the banking system (ex: banking affiliates): –Risk of moral hazard, –Remember that US subprime loans were primarily originated by non banking institutions. Banking is a confidence business no matter what: regulators need to be pragmatic when deciding upon the final calibrations of the NSFR and LCR ratios (40% cap on level 2 assets, calibration of corporate deposit outflows). Too much regulation kills regulation? The shadow banking system The shadow banking system is particularly big in the US. Globally, shadow banking account for 25-30% of the financial system. Source: Morgan Stanley/Oliver Wyman Excess return/capital requirement (%) of different asset classes under the draft solvency 2 rules

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