A new era after the crisis: from ROE to EVA

The global financial and economic crisis, which started in 2007 with the sub-prime crisis, has revamped the international cooperation and role of international multilateral fora in addressing the crisis’ challenges and defining a more sustainable international economic agenda.  

The international community and its most representative Institutions (G20, IMF, FSB, OECD) are obtaining impressive results in promoting a new global economic governance and a consequent more functioning financial architecture, even if a lot has still to be done. The  general guidelines agreed at G20 and FSB level have been transformed – in an amazing short time –  into new laws and regulations in the most relevant economic areas of the world. Banking business has become a global business and large banks are competing internationally for investors and business. It is, therefore, essential that the regulatory agenda agreed by the G20 is implemented in a consistent manner by all major jurisdictions. This is especially true for the Basel III framework. Such development has been a milestone and, we hope, also an irreversible process, whose contribution to face the crisis and overcome its after-effects has been fundamental. 

At European Union level it has been already implemented the new financial supervisory  architecture with the establishment of the new European Supervisory Authorities and the so called CRD III which embodies some of the new Basel agreements on banking capital requirements. Other measures are still under discussion (CRD IV, Deposit Guarantee Schemes, SIFIs, crises management framework, Derivatives clearing). However markets are already discounting most of the upcoming regulatory changes, even if  not into force yet, and particularly those deriving from the new capital requirements.

This has changed significantly the way banks look at and monitor their risk profile and capital/liquidity position. Banks will more and more focus on sustainable earning generation, with the definitive transition from an era based on the traditional performance indexes (e.g. ROE and ROI) to a world of more effective “risk adjusted” performance  measurement methods, which consider the cost of risk and the long term sustainability of profits (EVA etc.).

Higher capital requirements will pose a serious issue about profitability, as banks will necessarily need to increase their earning generation to remunerate the additional capital need. In turn, this might favor those institutions whose global business model is fee-intensive, penalizing traditional banks, where the possibility to increase fees is limited by fierce competition.

The increase of capitalization levels is often supported by the Authorities in the assumption that better capitalized banks are less risky, hence with lower cost of funding. However if (as it is happening now) markets force banks to adequate their capital ratios immediately to the future requirements (and not according to the transitional period as foreseen by Basel III – final application of the overall capital requirements by 2018 only), there might be a mismatch between the impact on the cost side, which is immediate, and the benefit coming from the market perception of lower risk of the banking sector, which takes time to occur. The higher capital and stable funding requested by the new rules will then have potential implications on the way banks manage their loan portfolio, thus on the real economy having either an impact on pricing to regain profitability or providing an incentive to the shadow banking system to the detriment of regulated markets.

The overall burden for the banking system of all the already implemented and implementing regulatory measures risk to be unbearable for the banking system, given also the still negative macro-economic scenario. A good number of European banks (e.g. Irish and British banks) is still using capital provided by the States, which will have to be paid back as well as the voluntary participation of several banks to the rescue of Greece (debt-rollover) will further reduce banks’ profitability.

Furthermore, the financial regulatory reforms could over-penalize those banking systems which did not originate the crisis and  that resulted in being more resilient to that. In this process of financial re-foundation, it is important to have clear in mind that there is a part of the world that caused the crisis (e.g. US and UK financial systems) and a part of the world that suffered from the crisis without having been responsible and – even more important – there are systems that managed the crisis better than others, like Italy, thanks to a more effective, intrusive and stringent supervision and maybe also to different business models. With regard to this latter aspect, it is a matter of fact that the more vulnerable banks during the crisis were the investment banks or, in the case of universal banks, those ones where the share of investment banking on the total activities was more relevant (e.g. German banks). In those countries where the banks were more traditional (i.e. carried out mostly the classic intermediation function and used for funding mostly the customers’ deposits instead of the more volatile inter-bank funds) the crisis impact has been much more softened.   

Intrusive, strong and independent supervision is therefore at least as important as a sound regulatory framework. The European Union has recognized this fact and put a new supervisory regime into place. Let us now hope that the newly created European Supervisory Authorities (EBA, ESMA and CEIOPS) can fully exploit their authoritative role and be supported by the national supervisory authorities.

Pushing for high qualitative European supervision and efficient co-operation between the EBA and national supervisors as well as the set up of structured system of crises management may prove an effective alternative to some parts of the envisaged regulatory changes and to the related large costs for the banking operators (capital surcharges for SIFIs are a good example).

Unfortunately the financial crisis turned into the sovereign-debt crisis. Certainly, Governments had to step in and play a vital role during the crisis. Over the short term, the fiscal stimulus as well as the direct support for certain individual financial institutions avoided the collapse of the financial service sector and therefore of the entire system. On the other side, these State’s actions originated significant public debt and a subsequent crisis of sovereign debt.

In some countries, like Italy and Spain, we are witnessing to a risk of reverse contagion: the banking system, which not caused the crisis like in the “English speaking” countries, could face a financial distress due to a possible sovereign-debt crisis (actually imported by contagion effect from other countries like Ireland and Greece). The worsening of sovereign rating causes, in fact, an exogenous increase of the corporate risk and, therefore, of the cost of funding of all the enterprises and banks operating in that country. Moreover, the deficit-cutting policies which must be implemented in those countries risking a sovereign-debt crisis can endanger the still weak recovery of the real economy with further negative spillover effects upon the financial operators.

Therefore, the national and international policy makers and regulators, in particular at European level, should consider all the above mentioned factors and the direct and indirect costs that the banking sector is already facing when they design the necessary and urgent policies in order to reach a sounder financial system and to avoid a worsening of the sovereign-debt and Euro crisis. A credit crunch due to a general crisis of the banking system can only have a further depressive impact on the rest of the economy starting a “vicious-circle” between the financial sector and the real economy.

Obviously, like the case of Greece shows, the European Governments as well as the International institutions have no other choice than to respond promptly with a more internationally coordinated action to avoid the European Single Currency crack down and to re-launch the EU economy, on the grounds of the recognition that a sovereign crisis of one country implies significant repercussions on the other EU Member States.

From the Governments’ side, in order to be more effectively pro-Europe, a broader European perspective should be adopted, combining the strength of national dimension with sharing relevant decision at European level. This is feasible if it is recognized that an important and shared common value is at stake. This is, nowadays, the large integration of the European people and of the commodities and financial markets, where EU cross-border banks play a crucial role in terms of financial resources allocation and economic growth.