Markets are Signaling Banks Face Challenges Other Than Financial Reforms

Regulatory reforms alone cannot explain the challenges facing the banking sector, according to Bank for International Settlements General Manager Jaime Caruana.

Speaking at an IESE Business School conference in London, Caruana said markets reflect an array of challenges facing banks.

"If we think of capital markets as a mirror, what are the reflections telling us about the current state of the banking sector? I believe they are quite revealing, especially about the pressures faced by banks as borrowers, and these pressures are contributing to the downward trend seen in bank leverage," he said.

Market observations, such as the subdued equity valuation of banks, the breakdown of covered interest parity and lessons from the "Great Deleveraging" episode of 2008, can shed light on some of the challenges confronting banks.

The moves to more and better capital are a response not only to regulation but also to market pressure, as the crisis experience has also sharpened the risk perception of banks, bank creditors and equity market investors.

Although there is considerable variation across regions in leverage and asset holdings, most banks' capital significantly exceeds the new capital requirements. But investor skepticism has been driving down share prices and penalizing banks when they come to borrow in wholesale markets.

"The high internal price on balance sheet usage in banks' capital allocation decisions may reflect factors other than regulatory capital," Caruana said.

Shun option of reinvesting profits 

Many banks also shun the option of reinvesting profits in favor of buying back shares and paying out high dividends, with average dividend yields for major bank stocks of around 5%. Repairing balance sheets and increasing capital through retained earnings and lower dividend payouts could help to mitigate investor skepticism.

BIS calculations show that a 1 percentage point increase in the equity-to-total-assets ratio of a bank could allow it to pay about 4 basis points less to borrow funds, and to increase lending to households and companies.

"To listen to some commentators, one would come away with the impression that the current problems weighing on the banking sector would disappear if only we dialed back the post-crisis efforts to strengthen regulation," he said.

"My arguments suggest that the diagnosis of what is ailing the banking sector is more complex. While regulation is one element of the business environment that banks take into account in their capital allocation decisions, the underlying challenges to banking in recent times seem to be more deeply rooted in low profitability and unnecessarily costly funding.

“Repairing balance sheets and increasing capital through greater retention of profit as retained earnings would mitigate many of the problems facing the banking sector. That being said, we will of course continue to monitor the effects of regulation on banks."

 

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