The scope of research undertaken into bank business models has been carried out not only to shed light on the architecture, performance, robustness and resilience of the European banking system, but also to demonstrate the relevance of the analysis as far as future regulation and resolution is concerned.
Without question, the banks’ risk modelling system has revealed a number of shortcomings – failings even – in areas of prudential policy. Indeed, as a result of on-going and ever-widening research, it’s become crystal clear that there needs to be an urgent overhaul of the current regulatory system underpinned in the Basel II risk system, if banks are to be more resilient against future financial shocks and not to cost trillions of dollars to taxpayers.
Published in January 2016, the Bank Business Models Monitor 2015 (BBM Monitor), in particular, exposed the continuing misalignment of regulatory indicators to the underlying risk of European banks – in particular in respects of risk weights and the Tier-1 capital ratio. This misalignment makes the regulatory ratio, mainly the Tier 1- Capital ratio – at best, unreliable.
Worryingly, even after the sovereign crisis in Europe, the zero risk weights that European governments are still exposed to, actually demonstrate the obsolescence of risk weights.
The BBM Monitor recommended, at the very least, that further improvements to the risk weights would be required to ensure any misalignment was dealt with. It also said there needed to be a rethink over the extent to which banks were allowed to use the Internal-Ratings-based Approach (IRB) particularly those banks that engage in model manipulation to minimise capital requirements.
Such was the importance of this subject that the recommendation was made for it to respond to the proposals put forward by the Basel Committee on Banking Supervision (BCBS) and those of European policy makers, to ensure that further misalignments were identified and handled within the Basel Accord and the Capital Requirements Directive and Regulation for Europe.
Continued Monitoring Remains Essential
Bank business models also demonstrated the need for regulation to be aligned as much as possible with the underlying risk profiles of certain banks, in particular in particular investment banks and retail diversified type 2 banks. Before adapting regulatory requirements to these bank business models, there would need to be a comprehensive review of their balance sheet and off balance sheets to understand the risks exposures and how they contribute to systemic risks over time.
Moreover, our research has shown that market perceptions are currently more aligned to the viewpoints of regulators, rather than to the intrinsic risk characteristics of banks. The underlying reason is in the external rating systems themselves, which are used by investors, regulators and sometimes banks. Market makers don’t seem to be able to take account of the business model risk factors associated with different types of banks. This may change in time, however, if more data becomes available.
Evidence of this can be seen in the proliferation of data emanating from listed and larger banks, which are required to provide more data to the market, in particular for shareholders. In contrast, the relatively little market data available from smaller and non-listed banks in the results – such as local cooperative banks – means it is difficult to form a precise judgment and understanding of their business models and, consequently, their risk profile based on accounting and market indicators.
This misalignment will continue as long as the transparency of small and non-listed banks doesn’t improve and if supervisors aren’t forthcoming in sharing whatever supervisory data they have in their possession with the wider market participants, including academics.
So continued monitoring of bank business models would seem to be essential to improve understanding of the risk concept, to shed light on the behaviour of banks from an asset and liability perspective and, ultimately, to detect the accumulation of risk at a system level, so it can be countered against.
Nevertheless, it seems that in each business model, there are better and worse performing banks, depending on the overall macro and micro economic conditions in which these banks are operating. Further research is being conducted to shed light on this aspect, but it is clear that business model analysis can prove useful in the policy debate on the future of micro-prudential regulation and its interaction with macro-prudential policy as well as structural reforms of the EU banking sector.
Predictive Powers of Business Models Analysis
The bank business model analysis also provides regulators and supervisors with essential forewarning powers to detect a build up of excessive risk accumulation at a system level. For example, what impact would a change of monetary policy in Europe and an increase in interest rates have on bank business models? As a result of the five separate bank business models identified in the research, there would almost certainly be a significant difference in how each type of bank would respond. For example, the banks that are funded by short term market funding and engage in long-term assets, would certainly suffer more than those funded by retail deposits and who engage in shorter-term assets. Some would be less resilient than others, particularly if they are not adequately capitalised. But with the analytical information now available, regulators and supervisors should be better placed to react and to intervene if required.
Moreover, understanding the systemic risk accumulation process is paramount to achieving a targeted macro-prudential regulation in close cooperation with active supervision. Grouping into a business model those bank institutions with a tendency to drive systemic risk upward, by acting accordingly with the appropriate regulatory and supervisory measures, would be the beginning of a new dynamic and targeted regulatory and supervisory framework. This would complement the current framework which is rather static, but once improved and coordinated, could work in tandem to prevent massive bank failures.
Equally, bank transparency and public disclosure practices, which are of fundamental importance to cross-border banking reviews and comparisons, remain a concern across the board. In the obtaining of data, bank business models have exposed the differences in definitions, limited disclosure and thresholds.
The public dissemination of supervisory data, which already happens in the US, and the implementation of standard disclosure formats, i.e. XBRL, could solve most data related issues. However, there might still be an issue with the application of different accounting standards, as well as with the extent and detail of information. If preventative measures are insufficient and banks do fail, then resolution must, at least, be well designed to ensure an orderly route towards liquidation or successful restructuring, without putting taxpayers in the firing line to save banks, as has been the case previously.
New Regulation at Work – Minimum Requirement on own fund and Eligible Liabilities (MREL)
In July 2015, under the Bank Recovery and Resolution Directive (BRRD), the Minimum Required Eligible Liability (MREL) was set out as an additional regulatory requirement for credit institutions across the EU.
Compliance with MREL implies that banks in the EU issue enough bail-inable liabilities to make a smooth resolution possible, which places minimal emphasis on taxpayers’ money or the resolution fund, neither of which would be sufficient to deal with another major financial or banking crisis.
The scope of MREL is broader than that of the Total Loss Absorption capacity (TLAC) standard put forward by the Financial Stability Board (FSB), in that it applies to all institutions, not only to the global systematically important banks (GSIBs).
It is vitally important the MREL and also the TLAC is calibrated to bank business models to ensure that, in the resolution phase, there is no mis-calibration which could be extremely detrimental to the overall recovery of the financial system.
This is a further example of how important bank business models can be a force for good in improving regulation and resolution, so that it becomes more relevant and practical to the changing face of the banking industry.
On a number of levels, then, but especially in the cause of safeguarding the banking sector against future risk, it seems highly likely that bank business models will become more forensic and more ubiquitous – and an invaluable tool for those tasked with regulation and resolution.
 A good summary on the regulatory issues at stake http://www.europarl.europa.eu/RegData/etudes/BRIE/2016/587361/IPOL_BRI(2016)587361_EN.pdf