Majority of British banks support EU capital law
Key survey shows benefits of capital directive set to outweigh costs. Many fears misplaced, says survey author Mark Tilden
The new EU capital adequacy rules for banks, due to be implemented from 2007, will improve risk management at British banks without causing many of the negative consequences that some critics fear. There is unlikely to be a sharp reduction in bank capital, or big changes in prices, volumes and market shares. Neither is the new capital regime expected to deepen the business cycle.
These are the conclusions of a survey undertaken by the US economic consultancy firm LECG for the Financial Services Authority (FSA), Britain's finance industry regulator. The survey* was a key input into the FSA's January Consultation Paper on the Capital Requirements Directive, which will transpose the new, risk-based, Basel capital accord - Basel II - into European law. The FSA's Consultation Paper lays out how the directive will be implemented in Britain.
LECG was commissioned to carry out a high-level study of the economic impacts of the various implementation options. It adopted a questionnaire and interview process to elicit views on the directive's implementation from representatives of the country's financial services industry. Senior executives were interviewed from nearly all sectors of the industry, including banks, building societies, private banks, trading and investment firms, asset managers, and brokerage firms. In total, a representative sample - by size and sector - of 47 firms and ninety-five individuals participated in the survey and interviews.
Information was gathered by the survey in two basic areas. The first area concerned the impact of Capital Requirements Directive (CRD) on the operations of individual firms. The second area of questioning concentrated on the impact of the CRD on Britain's financial services markets.
LECG also conducted an economic analysis to provide more context and some theoretical underpinning to the results which emerged from the interviews.
Impact on risk practices
The great majority of firms stated that the CRD would cause them to improve their credit risk management practices. A lesser majority stated that they would improve their operational risk management practices as a result of the directive. If it is accepted that a primary goal of CRD is to improve risk management in banks and other financial firms, then these results suggest that the regulation will be successful in one of its main aims.
Interviewees almost universally stated that the improvements in risk management practices embodied in the directive represented good `banking practice,' especially on the credit risk side. Many sophisticated institutions have, in fact, been heavily engaged in efforts to improve their risk management practices for as much as ten years. They often, therefore, saw CRD as a helpful spur to their activities, but not something fundamentally new and different for them. An implication of this is that CRD compliance activities are well advanced in many firms already, as opposed to the view of some observers that work on the directive is only just getting underway in the industry. Further, such activities would be going on even if there were no CRD.
Another finding is that firms are at very different levels of CRD readiness. While almost all firms felt they had much work left to do, some felt that they were already achieving rather advanced levels of sophistication in some areas of risk management, if not all. Typically, large, sophisticated banks and investment banks felt they were quite advanced in some areas. The areas in which they lagged tended to be in systems and infrastructure. Small firms, by way of contrast, had in many cases not begun serious work on CRD.
Non-credit firms
Non-credit firms is a term used to describe all the firms in the sample which have no, or minimal, lending or credit activities (asset managers, and brokerage firms, for example). CRD has a peculiar effect on such firms. Generally, they are affected only by the operational risk provisions of the CRD (since they have no, or little, credit activity). Since CRD introduces the need to hold capital against operational risk, such firms expected that they would be required to increase capital, sometimes significantly. Some felt that this was, potentially, a perverse outcome of the new regulation.
Credit firms (those that do lend), did not have the same concern, as they are affected by both the credit and operational risk provisions of the directive. Many banks feel that the credit risk side of CRD will result in significant capital reductions that will more than offset the capital effects of the operational risk provisions. They also see the directive as a useful encouragement of advanced credit risk techniques. Neither of these beneficial effects appear available to non-credit firms, which tend, therefore, to have a less positive view of the CRD than credit firms. Some felt that the rules were designed for banks, and that their application to non-credit firms was inappropriate.
Market impact
A key aspect of the research was to examine the potential impact of the CRD on financial services markets, and, specifically, whether the directive could cause changes to market elements such as prices, volumes, and market shares
The issue arises because there is a body of research and opinion that suggests the CRD will lead to a reduction in banking capital of many billions of pounds sterling over time. Textbook economics also suggest that if important inputs into the banking cost function, such as capital, are significantly changed, then this will feed through into pricing and volume changes via classic price elasticity functions.
While interviewees tended to agree that the CRD could lead to significant regulatory capital reduction, they did not agree that prices, volumes, or market shares would change as a result. Indeed, there was a strong consensus amongst those interviewed that the directive would have relatively little impact on these market elements. On the face of it, these two observations taken together are rather contradictory.
However, analysis can reconcile the two points to a considerable degree. Because of the very high leverage of banks, changes in capital have a surprisingly small, indeed, tiny, impact on the cost structure of banks. While interviewees had difficulty quantifying this, they had an instinctive feeling that changes in regulatory capital would not have major impacts on variables such as costs and prices.
Further research and interviews also demonstrated that heavily capitalised banks might not, in fact, reduce total capital very much as a result of CRD, even if regulators allowed a reduction in regulatory capital as a result of a bank's accession to the advanced credit risk measurement approach. This is because banks hold capital for a variety of reasons, only one of which is regulatory. This is a second reason why CRD might have limited impact on banks' cost functions, and, therefore, on pricing and volumes.
Impact on competition
Some commentators have suggested that large, sophisticated banks will gain competitive advantage over small banks as a result of the directive. They say a large, sophisticated bank quickly gains advanced status because of the amount of resources it is able to devote to the problem, and is accorded a significant capital reduction. By contrast, a small bank, with few resources and little sophistication, is `stuck' with relatively high capital levels because it is unable to accede to the higher levels of credit risk management under the CRD. A gap thus opens up between the two, which the large bank uses to gain competitive advantage over the small bank.
The findings from LECG's research did not support this scenario. Many small financial institutions participated in the survey, and not one felt seriously threatened by larger institutions in its sector. There were a variety of reasons. For the most part such institutions occupied niche markets within which they felt they could compete effectively regardless of any impacts of CRD. Also, an analysis of the cost `gap' that might open up between a large and small institution, once again reveals that the impact of the directive on cost functions is quite small. Many of the smaller institutions stated, also, that they would over time move to more advanced status, thus nullifying whatever cost disadvantage had emerged.
Impact on business cycle
Another issue with CRD is the view of some that it will exacerbate the business cycle. The reasoning is that banks will become more sensitive to credit risk, and therefore, much quicker to withdraw credit in a downturn. The view is that this would actually speed up an economic decline, and cause it to be deeper.Interviewees in the survey had divergent views on this question. The economic literature on the question is similarly divided in its views.
LECG comes down on the side of those who feel that CRD will not deepen the economic cycle. Many large banks said in the interviews that they had been using advanced risk management techniques for five years or more, and did not see any evidence in the marketplace or in their business that this had led to marked negative economic effects. There is also some economic literature which points in the same direction, noting that since the late 90's there have been a variety of economic shocks and difficulties, but that none of these had resulted in huge corporate bankruptcies, or massive loan write-offs in the banking sector.
Indeed, some commentators suggest that this relatively benign period is the direct result of improved risk management in banks. LECG's view was that, if advanced risk management techniques were going to have a cyclical impact, this would already have occurred, and been remarked upon, as such techniques have been in use for quite some time, according to the interviewees.
Cost benefit analysis
A key issue for the FSA was to assess whether the CRD would result in a positive cost benefit analysis. While non-credit firms were sceptical about the benefits of the directive, and concerned about potential costs, credit firms had a cautiously positive view about CRD's cost benefit ratio. This is because, as bankers, they felt the directive encourages good banking practice in risk management, has the potential to generally raise standards in the industry in this critical area, and offers potential capital reduction.
The primary concern that emerged, held chiefly by large, sophisticated institutions, was that the FSA would take a prescriptive approach to the CRD's implementation. A prescriptive approach would in their view be unhelpful because it would almost certainly lead to a rework of risk management systems that were already built and functioning, but which did not accord with a highly prescribed FSA solution. These large institutions preferred an approach where the regulator would judge the `outputs' of their systems, not the detailed inner workings. Smaller institutions, by contrast, wanted detailed guidance from the FSA as this would give them a `roadmap' to guide their efforts. Since most of them were just starting their implementation, they had few concerns about `rework.'
Cost benefit analysis is applied not only at the firm level, but also at the level of the financial system and UK economy as a whole. LECG's view, and that of interviewees, was that CRD would undoubtedly improve the strength and resilience of the financial system, by making it less vulnerable to credit shocks.
Mark Tilden is director of financial services (London), at economic consultancy LECG
* LECG's full report is available on the FSA's web site as Appendix Two of the Consultation Paper.
