Regulating Non-bank Finance: Options and Implications Speech by Klaas Knot at the launch of the FSR, Banque de France, Paris, 25 April 2018 In his closing Key Note speech at the FSR launch at Banque de France, Klaas Knot first sums up the benefits of the Capital Markets Union, before stating that more policy efforts are needed to reap these benefits. Knot then compares Regulation of entities to Regulation of Borrowers. 1
Ladies and gentlemen, I would like to thank the organizers for their kind invitation to contribute a paper to the Financial Stability Review and deliver this closing speech. My written contribution focuses on the increasing role of institutional investors in the Dutch mortgage market. I would like to use this opportunity to provide a broader perspective on regulating non-bank finance, from a financial stability perspective. My starting point is that we need a prominent role for non-bank finance, including both debt and equity, to complement Europe s strong tradition of bank financing. This is, of course, exactly what Capital Markets Union the CMU - is trying to achieve. Let me briefly recall the main benefits. Figure 1: Main benefits CMU First, the CMU would make it easier for savers and investors to diversify their investments within the EU to seek the best return. Second, the CMU can provide businesses, and especially SMEs, with better access to funding. Financial intermediation is heavily bank-based in the EU. This needs to be complemented with a better availability of equity, to finance innovation that is crucial for productivity growth. Third, the CMU can enhance private risk sharing via cross-border integration. This is very important, also in the context of our single currency, as private risksharing helps the absorption of asymmetric shocks. Research suggests that in well-functioning federations - like the US, Canada and Germany - private risksharing plays a more important role in the absorption of regional shocks than public risk-sharing via a federal budget. In the euro area, these private risksharing mechanisms are still underdeveloped. 2
Finally, a well-diversified CMU enhances the resilience of the financial system, as its financial structure becomes more balanced. But I agree with you, Governor François Villeroy de Galhau, that more policy efforts are needed to reap these benefits. I support the points that you raise in the opening article of the Financial Stability Review, on the need for a coordinated approach and concrete progress in areas such as accounting, taxation and insolvency laws. In sum, CMU is highly desirable. And its development should go hand in hand with proportionate measures to contain financial stability risks. The relevance of appropriate regulation beyond banking is illustrated by this recent quote from your President: We need to look again at financial regulation and focus on shadow banking in particular, and think about investors that are not properly regulated today 1. It focuses attention on a key question: how to regulate a financial system where bank and non-bank types of debt co-exist. This brings me to the second quote from Nobel prize winner Bengt Holmström. It was taken from his paper on the role of debt in the financial system: Why all financial panics involve debt 2 A financial panic may occur, so goes the argument, when we move from a situation in which repayment on debt is taken for granted towards a situation in which repayment is no longer taken for granted. In such a situation, debt holders suddenly face the prospect of becoming the owners of the underlying assets or collateral. These have a highly uncertain value at that point, hence the panic. Shocks that trigger such a response could for example be unexpected large movements in asset prices or interest rates. Holmström directs our attention to the link between debt and financial stability. I note that his theory is not restricted to bank debt only, as illustrated also by the break-down of the market in asset backed-securities during the crisis. Both bank and non-bank debt should therefore be included in our overall analysis on the need for financial stability regulation. 1 Contribution of Emmanuel Macron to a European Commission-organized conference on sustainable finance, March 2018 2 Bengt Holmström (2015), Understanding the role of debt in the financial system, BIS Working Papers No 479 3
Figure 2: Growth of non-bank credit So what are the effects of current regulation, both on bank and non-bank debt? As you may know, almost all macroprudential regulation has so far focused on banks. DNB researchers have used this fact to estimate the effects on both bank and non-bank credit developments 3. Results as summarized here, suggest a dampening effect on bank credit: the light green line. But also an increase in nonbank credit: the red line. The overall effect on total credit still appears negative, with the caveat that the estimations are subject to substantial margins of uncertainty. I believe that these substitution effects from stricter regulation on banks, both micro and macroprudential, do matter in practice. You can see it for example in the first Chart in my paper for the Financial Stability Review. It shows the increasing share of non-bank mortgage loans in The Netherlands. And we can see such effects in other countries and for corporates as well. In particular, research from the New York FED shows that the US bank guidelines for leveraged finance have led to a substantial substitution effect towards nonbank credit. The authors of this study therefore doubt whether the broader goal has been achieved, which is to reduce the risk that these loans pose for the stability of the financial system 4. 3 Cizel, Houben, Frost and Wierts (2016), Effective Macroprudential Policy: Cross-Sector Substitution from Price and Quantity Measures, IMF Working Paper (currently under revision for the Journal of Money, Credit and Banking) 4 Kim, Plosser and Santos (2017), Macroprudential Policy and the Revolving Door of Risk: Lessons from Leveraged Lending Guidance, Staff Report No. 815 4
This brings me to the different options for regulation. Figure 2 below illustrates that credit can be provided by bank and non-bank entities, which can be national or foreign, and take the form of loans and securities. Figure 3: Two options for regulation This corresponds to debt from the perspective of borrowers in the non-financial private sector, which can be households or corporates. Hence, if we are concerned about excessive debt and credit from a financial stability perspective, we have two basic options: regulate entities, to address the usual bank-like risks. We can regulate banks, e.g. through rules on their exposures or capital standards. But we can regulate non-bank entities as well. This point has been covered already in the opening article in the Financial Stability Review that will be published today. Governor François Villeroy de Galhau argues that especially the liquidity of non-banks is a priority for financial regulation. And I fully agree. Take the perspective of the borrowers in the private sector households and corporates - and a desire to restrict how much debt they can take on their balance sheet. In principle, this can cover all forms of debt, from bank and nonbank sources. As an illustration, The Netherlands is one of the few countries where we actually do so: our LTV limits cover all types of debt. Other EU countries that apply borrower-based measures to non-bank debt, are Ireland and the UK, according the latest FSB Global Shadow Banking Monitoring Report. So what should we regulate and why? I believe that the answer depends on the objective that you want to achieve. 5
Figure 4: Why regulate? If the objective is to safeguard the resilience of entities, such as systemically important banks, entity-based regulation is the way to go. But if we also want to guard against the build-up of excessive debt at the level of borrowers, borrowerbased regulation appears necessary. And a rather ambitious objective would be to actively lean against the credit cycle. To finalize let me give you my personal take on this. On the first objective, the bank-based approach has already received a lot of attention and rightly so. This includes the Basel agreements and macroprudential measures levied on banks. The substitution flows that we see suggest that these rules have an effect. And I already referred to one of the next steps which is to look further at the liquidity of non-banks. On the third objective, I believe that going beyond the countercyclical capital buffer by actively steering the credit cycle may be quite ambitious. Our instruments may not be effective enough for fine-tuning credit developments, as the incentive for circumventing would become strong. If anything, it seems that actively dampening credit flows could require tough measures that are hard to reconcile with the need for credit in the real economy. And timing would be difficult, as there is considerable uncertainty on the phase of the credit cycle in real time. Just as there is considerable uncertainty around output gaps in the real economy. That brings me to the second objective related to borrower-based measures. This objective appears especially relevant at the current juncture due to worries about high debt-service ratios in the context of prospective increases in interest rates. Moreover, I already mentioned shifts in mortgage financing towards nonbanks and the need for LTV and LTI limits that apply to both bank and non-bank credit. 6
But developments on the corporate side also illustrate a need to take a broad approach. To curb excessive leverage in the market for leveraged corporate finance, which is quickly picking up, both the SSM and US Agencies have issued guidelines for banks. These guidelines warn against lending to corporates when debt to EBITDA 5 exceeds six times. This has contributed to a shift towards nonbank credit provision in the market for leveraged finance. I am also very interested to hear more about the French context. As I understand, you are in the process of imposing new measures for systemically important banks that lend to highly leveraged corporates against the background of the current boom in leveraged lending, and in part since the build-up of debt at corporate level contributes to systemic risk. I understand that the thresholds at corporate level deliberately cover bank and non-bank debt. And that the entity-based measure on systemically important banks appears the most appropriate and feasible one also given the available legal base. In line with my story so far, your notification to the European Systemic Risk Board indeed notes that there may be some substitution effects from non-bank lending to corporates. I take your point that these may be limited in this example due to the broad scope of the corporate threshold and the signaling effect of your measure for non-bank lenders. In any case, given that bank and non-bank credit both play important roles in these markets borrower-based measures could perhaps also be discussed. Such measures would support current entity-based measures with a borrower-based approach applying to all types of credit. This would obviously require substantial further analysis. Not in the least since this market is very international, so that a borrower-based measure should be considered at EU-level. This is just one suggestion as part of a broader policy agenda. We move towards a well-functioning Capital Markets Union, delivering a diverse set of financing options to the real economy. And we should complement this with regulation that curbs risks to financial stability stemming from non-bank finance. Thank you for your attention. 5 EBITDA: Earnings Before Interest Taxes Depreciation and Amortization 7