THE POST-CRISIS CAPITAL ADEQUACY FRAMEWORK FOR EUROPEAN BANKS: A TRADE-OFF BETWEEN FINANCIAL STABILITY AND PROFITABILITY?

In the wake of the recent global financial crisis, the international, cross-border connections between banks and their vulnerabilities to systemic shocks were starkly highlighted by the rapid contagion that spread from the US interbank and financial sector to European markets in 2008. The vulnerability of national economies to the downturn in the banking sector and the precipitous cost of bank bailouts to both governments and taxpayers following the crisis served to further emphasise the intricate and often opaque links between banks, their stakeholders and the broader economy. At the same time, the financial crisis revealed the severe risks that lie behind the profound degree of interconnectedness that global capital markets and cross-border banking services have reached in the last forty years – what has been defined in the literature by numerous policy commentators as ‘financial globalisation’. Without appropriate governance systems and regulation at the international level, the disastrous economic and financial effects of a systemic banking crisis may be virtually uncontrollable for any sovereign nation. Faced with the need for immediate mitigation and deeper regulatory reform, international standard-setters, under the aegis of the G-20 and the International Monetary Fund, as well as EU lawmakers at the regional level, were swift to respond. Consequently, since the crisis first hit European shores and triggered the sovereign debt crisis, EU financial regulation has significantly evolved in terms of supervisory infrastructure and substantive reach. In the aftermath of the crisis, EU authorities realised excessive risk-taking behaviours in the run-up to the crisis were supported by the belief of many European bankers that their institutions were too big to be allowed to fail, also as a consequence of the deferential and accommodating, insufficiently challenging, supervisory approach that national public authorities had vis-à-vis the domestic banks they had to supervise. As a result, the reform process at EU level to denationalise prudential banking supervision and resolution to ensure a level playing field among European lenders and their capital soundness brought to the establishment of the Banking Union, that is the most far-reaching reform of institutional harmonisation and supervisory centralisation within the Euro area since the creation of the euro. Indeed, the Banking Union project launched in 2012 by EU authorities can be considered a reform comparable in importance to the customs union (1957), the competition framework (from the 1960s onwards), the single market (1990s), or, most recently, the launch of the euro (1999). In line with international recommendations, the Banking Union has been established as a regulatory framework, or European financial safety net, built upon three pillars, which centralise to the European level administrative functions carried out, until the establishment of Banking Union, by Euro area national authorities. The first pillar establishes a single mechanism for the supervision of banks, the second pillar lays down a Eurozone-wide integrated crisis management regime, and a third pillar (in contrast to the other two pillars, at present not operational yet) would provide for a common system for deposit guarantees. For Eurozone credit institutions, this ‘Copernican revolution’ in the institutional banking environment, coupled with the approval of the Basel III Accord by the Basel Committee on Banking Supervision, has translated to more stringent capital requirements and higher compliance costs on, among others, liquidity risk management mechanisms, reporting obligations and loss-absorbing resolution regimes. Indeed, the implementation of the Basel III framework within the EU legal framework, which occurred by means of two separate legislative streams over a time period of six years (2013 – 2019), came at a significant price. Compliance with the new prudential requirements, and particularly capital standards, required banks to sustain tremendous costs – in the range of trillions of euro – for recapitalisation and risk management improvements. A significant number of banks preferred to re-size their balance sheets, deleverage on risk-weighted assets and rebalance their portfolios. Over time, this structural transformation has had an impact on the profitability drivers of the banking sector and the broader economy, resulting in what a growing body of quantitative studies defines as a decline in credit availability for large corporates, small and medium enterprises and households, and possibly a decline in gross domestic product growth. As a whole, the consensus in the relevant academic literature suggests that an increase in capital requirements has a positive impact on the real economy in the long term by reducing the probability and the impact of a banking crisis, while reductions of the loan supply and deleveraging of exposures are likely to occur in the short term. The afore-mentioned prudential concerns introduce the ultimate objective of this doctoral work, that is to assess the post-crisis EU capital adequacy framework applicable to Eurozone credit institutions under the first and second pillar of the Banking Union, i.e. the Single Supervisory Mechanism and the Single Resolution Mechanism. In particular, of all the regulatory changes that have been introduced by the CRD package, the increased minimum capital requirements, although well-meaning, pose a challenge for many European banks. Further idiosyncratic factors negatively affecting the profitability drivers of European lenders, namely negative interest rates, the Fintech revolution and stark competition in overbanked markets, do not help to assimilate the new capital regulations while offering return on equity to investors. Additionally, Eurozone banks have now to interface with competent and authoritative administrative supervisory and resolution authorities, i.e. the European Central bank and the Single Resolution Board, which have been entrusted with a broad prudential and sanctioning toolkit, together with intrusive authorisation powers relating to the computation of financial instruments in the banking regulatory capital and the use of internal models to calculate minimum capital levels. Against this backdrop, this work aims at connecting several strands of the literature. The literature on banking capital requirements is the obvious starting point. In this sense, Chapter One will analyse the prudential standards embedded in the Basel Committee on Banking Supervision soft-law international framework and their application to large, internationally active banks. The content of the Chapter will deal, in particular, with the prudential requirements relating to the quality and composition of the banks’ capital base and the function that banking capital has recently assumed as to safeguarding financial stability and ensuring market discipline vis-à- vis investors, markets and depositors. The aim of the Chapter is to shed light on how the Basel Committee on Banking Supervision’s supervisory framework flexibly evolved over the decades in response to different global sovereign or financial crises, with the primary goal to ensuring international financial stability and the soundness of financial institutions. Chapter Two will turn the focus on the European Union. In particular, Chapter Two will discuss the establishment, in line with recommendations from the International Monetary Fund, of the Single Supervisory Mechanism, as transnational banking supervisory net composed by national and supranational authorities and as first pillar of the ambitious European Banking Union project. Accordingly, Chapter Two will illustrate the key reasons why the Single Supervisory Mechanism constitutes a ‘Copernican revolution’ in European administrative and banking law, and the way in which it created a complex, multi-layered pan-European system of prudential supervision that significantly reshaped the operation of public supervisory administrations within the Eurozone (and the non-Eurozone Member States participating to the Single Supervisory Mechanism – currently two, Bulgaria and Croatia). Under this perspective, Chapter Two will discuss in detail the macro- and microprudential supervisory tasks and powers that have been centralised to the European Central Bank to ensure compliance by Euro area credit institutions with the Basel prudential standards (and the implementing European legislation). To this end, Chapter Two will discuss the European Central Bank’s supervisory decision-making structures deputed to adopt regulatory acts and administrative individual supervisory decisions addressed to significant credit institutions as well as, where applicable, less significant credit institutions. In line with the arguments developed in Chapter Two, Chapter Three will focus, specifically, on a sub-set of prudential tasks and powers entrusted to Banking Union authorities, i.e. the European Central Bank within the Single Supervisory Mechanism and the Single Resolution Board within the Single Resolution Mechanism, namely prudential tasks and powers over the capital of Eurozone credit institutions. In this context, Chapter Three will analyse, among others, under what conditions significant Eurozone banks may receive permissions from the European Central Bank, as prudential supervisor, to compute financial instruments as capital for regulatory purposes, to reduce their own funds and to use internal measurement approaches to calculate risk- weighted assets and minimum capital levels. Correspondingly, Chapter Three will also discuss the public administrative powers that have now been centralised to the Single Resolution Board in respect of reductions of eligible liabilities. Finally, Chapter Three will analyse the early intervention powers and sanctioning measures centralised to the European Central Bank in case of non-compliance by Eurozone banks with capital adequacy provisions. Last, Chapter Four concludes with a critical assessment of the Banking Union project and the newly established European capital adequacy framework, also by relying on quantitative academic literature assessing the costs and benefits of banking capital requirements. In particular, Chapter Four will illustrate how financial stability represents an outright objective of EU banking legislation and the main reasons for subdue profitability of Eurozone banks. On such basis, Chapter Four will conclude with a critical analysis of the positive achievements and the unexpected drawbacks of the recently reformed European capital adequacy regime, and the expected impact of new Basel IV Accord on European banks. Finally, it will put forward policy recommendations aiming at, on the one hand, removing regulatory obstacles in European banking legislation in order to support the creation of a banking sector truly pan-European and ease the profitability malady of Euro area lenders, while, on the other, ensuring full judicial protection of European banks against certain micro- and macroprudential supervisory decisions adopted by the Single Supervisory Mechanism and imposing higher capital requirements, as mandated by the Charter of Fundamental Rights of the European Union and the Treaty on the Functioning of the European Union.