The battle over the future structure of financial institutions will affect indexing as well.
It’s impossible to open a financial publication these days without sensing the major, often behind-the-scenes conflict that’s going on over the regulation of the banking sector.
Its central front is the head-to-head confrontation between regulators and financials over bank capitalisation and the “too big to fail” (TBTF) issue.
The UK’s Bank of England has been striking a belligerent posture in recent weeks, calling for a doubling or tripling of tier one bank capital from the minimum 7% of risk-weighted assets set out in the Basel III rules.
Mervyn King, the Bank’s governor, recently repeated his call for the break-up of banks into separate investment and retail arms, with a state guarantee on offer only to the restricted, retail part. Andrew Haldane, executive director for financial stability at the Bank, gave a presentation to the Institute of International and European Affairs in Dublin earlier this year (available here), in which he makes it pretty clear that tackling TBTF (and reducing or eliminating the possibility of the financial sector ever offloading its liabilities on the taxpayer again) is concern number one in Threadneedle Street.
Similar debates are taking place elsewhere, although in the US market the former central bank chairman is striking a stance that’s much more pro-financials, anti-regulation. In an opinion piece in the Financial Times from earlier this week, Alan Greenspan argues against excessively strict implementation of the Dodd-Frank act.
(Greenspan’s central argument is that financial markets are driven by an international version of Adam Smith’s ‘invisible hand’ and are therefore best left to their own devices. “With notably rare exceptions (2008, for example), the global ‘invisible hand’ has created relatively stable exchange rates, interest rates, prices, and wage rates,” he says. Perhaps Dublin’s IIEA—Irish taxpayers were yesterday landed with a new bill for their country’s bank clean-up, amounting to a whole year of gross income for each worker in the country—should invite him to defend his thesis in public.)
The response of the banks has been fierce. In the UK, both HSBC and Barclays have repeated threats to leave the country. In the US, JP Morgan’s chairman, Jamie Dimon, spoke out on Wednesday against a provision in Dodd-Frank that would require US banks to spin off their over-the-counter (“OTC”) derivatives operations.
Increases to capital requirements, while reducing the overall risk of banks, would also slow down the manic pace of financial sector innovation and put downward pressure on pay (lower leverage in banks means reduced share price volatility and a reduced value for the major part of financial executives’ remuneration that comes in the form of a call option on future performance).
There are other consequences of proposed changes to the regulation of financial derivatives. As Tracy Alloway described on this site a few weeks ago, the push towards central clearing has implications for collateral costs and therefore for the overall economics of the business of swap providers. Two-thirds of Europe’s exchange-traded funds are swap-backed.
While swap-backed ETFs have to be collateralised to a minimum 90% of net asset value, the provision of collateral both to a higher percentage and in a higher quality form would impact issuers’ profitability. But that’s the way the market is moving. In the words of one panellist at Data Explorers’ Securities Financing Forum, held in March, “all of the derivatives world is moving towards collateralised structures. And people want high-grade collateral, while not everyone has it.”
Meanwhile, the business of securities financing itself—something key to the operation of a range of exchange-traded and index funds—”was under the radar of regulators for a number of years, but is now paying the price”, according to Kevin McNulty, CEO of the International Securities Lending Association, speaking at the same event.
The battle over financial regulations is one reason we chose the subject as the central theme of our inaugural Journal of Indexes Europe issue (the publication, entitled “Shifting Regulations”, is due out in a couple of weeks and you can register for a free subscription here).
We’ll also be covering the changing regulatory landscape in detail at our forthcoming Inside ETFs Europe conference in Amsterdam on May 5/6. (Admission is free to institutional investors and the event is filling up fast, so please register to join us). The conference has separate panels devoted to both tax and regulation, with high-level speakers on both subjects. I, for one, am looking forward to those discussions with particular interest.