European Bank Regulation: Expect a Shift

Regulatory uncertainty will create opportunities for private capital as banks retrench from some lending markets.

The European banking sector is transitioning from one tacitly backstopped by a sovereign-banking link toward a utility model where the private sector bears a majority of potential losses. This has created uncertainty over regulatory initiatives, such as implementation of the European Union’s Bank Recovery and Resolution Directive (BRRD) and increases in operating capital – resulting in volatility across the capital market, European bank equities in particular. More importantly, the void created by this transition is affecting important segments of the lending market. We believe this holds two important investment implications:

  • One, banks will continue to retrench from certain lending markets, with non-prime borrowers in weaker sovereign jurisdictions most affected. We believe this will present one of the better secular investment opportunities in Europe for private capital able and willing to fill the financing gap.

  • Two, to ebb these uncertainties and encourage private investor capital with the prospect of reasonable returns, policymakers will ultimately support a more collaborative, simplified and investor-friendly regulatory regime. Select higher-beta bank equity investments will likely benefit the most when this shift happens.

Manifest Costs, Masked Benefits

Regulations enacted in the aftermath of the great financial crisis have led banks to focus on prime and super-prime credits. For banks, this enabled lower operating costs, fewer non-performing loans and a reduction in the amount of capital they must hold – thus helping some banks’ return on equity to return to double-digit levels.

Importantly, these regulations also contributed to a delinking of banking from sovereign solvency. The goal is to create a safer, well-capitalized banking system where the private sector bears the vast majority of the losses if or when an entity fails – not society, i.e., the taxpayer. We agree with this long-term objective.

That said, it’s important to remember the reasons why this link existed historically. This sovereign/banking link is effectively a government subsidy to the financial community to achieve two objectives: a) reduce overall financial volatility and b) increase credit availability, particularly to middle and lower income borrowers and companies.

The benefits of the sovereign/banking link are seldom discussed because they accrue to society over time, while the cost to society is realized at one point in time – i.e., covering tail-event losses – often during a period of significant economic stress, and as such is politically charged. Moreover, the existence of this subsidy allows for outsize returns to a select group of individuals and entities, which is a source of consternation. Gains therefore are deemed private and losses socialized. Nevertheless, there are broader benefits, namely access to credit, which is more widely distributed at a lower cost as the transmission mechanism is simplified. Despite all the political wrangling when taxpayers have to occasionally pay for the subsidy, the long-term cost is usually quite manageable because these banks typically return a good portion, if not all, of the outlay from the government over time through earnings.

Ideally, policymakers seek to strike the appropriate balance between capital, regulation, risk-taking and investor returns. It’s not easy. If successful in its implementation, the upgraded European regulatory regime will reduce volatility (and ultimately the likelihood of future taxpayer subsidies). With it comes trade-offs, which to date have been seldom discussed. Both debt and equity investors will likely demand higher risk premiums and/or become more risk-averse (see Figure 1.) Investors may even require an additional risk premium for smaller banks, particularly those in weaker jurisdictions, due to their uncompetitive position, thus further restricting lending to non-prime borrowers as banks will choose to focus primarily on more profitable prime borrowers and fee-based businesses.

Another reason for higher risk premiums is that without a government backstop, some weaker banks could potentially be driven into insolvency during bouts of market turbulence or weak economic periods. If investors – who are now responsible for the bulk of the losses in the banking sector and who have little legal representation in insolvency – believe their capital is at risk, they will likely respond by reallocating capital and doing so in a disorderly manner. Potentially, this could result in a reestablishment of the banking/sovereign link and exacerbate the risk to an economy as well as to the sovereign. For better or worse, this reinforces one of the primary reasons why the government/banking link existed in the first place – to support both banks and the broader economy during rougher periods.

The Link Unbroken

The primary way to address these risks without a government subsidy is to be highly confident that banks are making relatively safe loans and are overcapitalized – the comparison is often to make banks more like utilities. While beneficial for debt investors, equity investors will continue to seek returns on equity higher than a utility bank model would suggest until uncertainty wanes, particularly with respect to the regulatory environment.

What does this mean? In the near term, we expect private capital, particularly in weaker sovereign jurisdictions, to provide more financing to higher-risk, non-prime borrowers; it will accept both market and credit volatility for the prospect of higher premiums. Thus, we expect there to be numerous areas where the non-banking community can make loans with attractive risk-adjusted returns – for instance, by lending to individuals buying homes or automobiles or by financing trade among small- and medium-sized businesses. Indeed, we’ve already seen private equity and hedge funds, venture capitalists and family offices acquire profitable and traditional lenders of this sort.

Recently, there have been signs that Europe is shifting bank regulation in more investor-friendly directions. The European Central Bank’s 10 March move to reduce rates and purchase corporate bonds, for instance, should reduce tail risks for banks.

We are not advocating a return to the government/banking link that existed prior to the onset of the financial crisis; we are simply highlighting that there was a rationale for its existence. Importantly, without a shift in the regulatory environment, investors should expect a) a re-pricing of risk premiums that would constrain some banks’ ability to lend and/or b) the withdrawal of private capital from banks, particularly in the periphery. Neither is sustainable so a regulatory shift should be expected. Investors would be wise to monitor these developments closely.

The Author

Joshua Anderson

Portfolio Manager, Opportunistic Mortgage and Real Estate

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