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Central Bank Regulations: What You Need to Know Now

Recent regulatory changes should improve transparency and liquidity. But there remain a lot of uncertainties.

Sinan Baskan, Vice President, Capital Markets, SAP
Sinan Baskan, Vice President, Capital Markets, SAP
European capital markets have seen a number of regulatory changes over the past several months. At least some of those developments have been favorable to financial institutions.

But many policies and regulations continue to be in flux. And the long-term economic health of several EU members is still unclear. Now more than ever, financial institutions need to remain watchful as the implications play out, especially for those operating in the weaker European economies

Many Moving Parts

Several significant regulatory events are driving both change and uncertainty in European capital markets. These make for a large number of moving and interconnected parts.

First are new activities within the EU’s European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA). EBA’s mandate ranges from economic capital standards enforcement to supervising stress tests on European banks and securing transparency in the European financial system. ESMA regulates credit-rating agencies such as Moody’s and the integrity of market operations.

The scope and enforcement powers of EBA and ESMA are expanding. EBA will have oversight of the valuation practices and quality of high-risk assets and the methodology for calculating leverage ratios. Since the recent relaxation of leverage-ratio and liquidity-coverage frameworks by the Basel Committee, there’s increased ambivalence about the extent of the enforcement process. ESMA will supervise the processes for trading settlement, collateral management, reporting cash transfers, and accounting for transactions between counterparties.

Two new directives add to the emerging uncertainty and complexity. One is the Bank Recovery and Resolutions Directive (BRRD) of the EU’s Economic and Financial Affairs Council (ECOFIN). BRRD is designed to ensure that investors, rather than taxpayers, bear losses associated with carrying risky assets on the banks’ balance sheets while limiting instability in financial markets.

The other is the Basel Committee’s proposed revisions to the Net Stable Funding Ratio (NSFR). NSFR calculates the proportion of long-term assets funded by stable funding such as customer deposits and long-term wholesale funding. The revisions are intended to achieve better alignment with the Liquidity Coverage Ratio (LCR), reduce cliff effects in the measurement of funding stability, and increase focus on short-term, potentially volatile funding sources. In general, these changes should be favorable to the stability of financial institutions, but they’re likely to reduce overall liquidity for high-risk asset classes.

An additional, more recent, change is the Alternative Investment Fund Managers Directive (AIFMD), which directly affects high-risk, cross-asset arbitrage strategies. The directive, which went into force in July 2013, regulates asset managers who have alternative strategies such as hedge funds, commodities investments, and real-estate trusts. It may remove some higher-risk capital from the European market and reduce volatility on the buy side of the market

No Clear Picture Yet

Exactly how all these regulations will balance out in the aggregate is uncertain. The revised leverage ratio should provide additional liquidity to the European market and help the weaker economies, because some securities, especially sovereign debt, may become more attractive. However, NFSR and LCR will act as a speed bump and counterweigh the effect of the new counsel on leverage ratios.

The expanding role of central banks will require a new balancing act, as well. Central banks are becoming influential in prudential supervision of interbank operations and asset management operations in ways it never did before. The mandate to control inflation is still the leading priority.

The uncertainty is exacerbated by artificially low interest rates. Central banks could certainly raise interest rates and have some impact on economic growth rates. The net effect of the new directives may be reduced liquidity to further accentuate slower growth from higher interest rates. If the net effect is higher liquidity, there may be more maneuvering room for increasing rates.

A Chance for Sustained Stability

These recent regulatory developments are discrete efforts that lack a broader regulatory framework that includes monetary policy and an anti-inflationary stance. It’s difficult to envision what financial markets in the 28 EU member nations will look like in the next two to five years as a result of the new regulatory regime. Clearly, an imposed stability by directive and stagnation will deliver lower volatility in markets. It’s also likely there will be no chance for a comprehensive policy until major EU economies see growth rates of at least 2.5 percent and unemployment is steady or, ideally, starting to fall.

In the meantime, financial institutions can be encouraged by some of the positive developments. Because of relaxation in the leverage ratio, there has been improvement in the funding capacity of healthier financial institutions. So there’s hope for more liquidity in the securities market. Under ESMA, there should be more uniformity and transparency in market operations. That will facilitate inter-European capital flows and bring capital that’s currently parked on the sidelines back into the market.

What financial institutions need to hope for is that these regulatory changes have some positive impact on issues like trade deficits and fiscal deficits in troubled economies. If they do, then their other favorable outcomes should be sustainable going forward.

Sinan Baskan is Vice President, Capital Markets for SAP. He is responsible for developing integrated solutions for Capital Markets and Business and Ecosystem Development. His team has developed and delivered solutions for e-Trading, Risk Analytics and Regulatory Reporting and Compliance for financial services customers. Prior to his current position, Sinan was Vice President of Risk Technology for the Americas at HSBC Corporate and Investment Bank. He has held positions in engineering and product management at Sybase (1993- 2005) and rejoined Sybase in 2007. He started his career at Philips Research Laboratories and at IBM Research Division.

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