Two senior European investment bankers told a European Commission hearing that tougher bank capital and liquidity rules were forcing banks to shrink and de-risk their balance sheets, and to deprive markets of liquidity.
"Banks are stronger, but markets are much weaker. The reason why markets are weaker is exactly because banks are stronger," said Sylvie Matherat, chief regulatory officer of Deutsche Bank.
"Banks are much more liquid than they were in the past, but in fact we keep the liquidity for ourselves, and there is much less liquidity in the market."
The question of whether or not there is a link between the tougher prudential regulation following the 2008 financial crisis and decreased market liquidity is the subject of sometimes heated controversy and academic debate.
"I can tell you, as a practitioner, that this link is real," Philippe Bordenave, chief operating officer, BNP Paribas, told the hearing, which the commission convened at its Brussels headquarters to hear views on its review of the European Union's 40 post-crisis legislative and regulatory packages.
Matherat and Bordenave both listed products and business lines that Europe's investment banks have exited as they have cleaned up and shrunk their balance sheets in order to comply with the tougher capital and liquidity requirements. These included non-euro area mortgage lending, long-term derivatives, long-term leasing, single-name credit default swaps (“CDS”), "most project finance", and letters of credit.
Even correspondent banking with any but the largest and best known international banks is being affected, although here, conduct risk plays the major part: "You need to know not only your customer, but the customer of your customer: that is something that it is just not possible to do," said Matherat, who is a member of Deutsche Bank’s management board.
"Everything that is balance sheet-intensive, we don't do anymore," she told the hearing. While a number of business lines on the asset side generated insufficient capital under the new regulatory framework, ultra-loose monetary policy also created liabilities problems.
"On the liabilities side you have something you can't do anything with, except go back the European Central Bank and lose money on it, so you lose on both sides – not a good business model," she said.
Bordenave acknowledged that the tough Basel III rules had brought "an unprecedented strengthening of European banks' balance sheets", with Tier 1 common equity doubling, even taking into account the stricter calculation of own funds in Basel III, which he said had cost his own bank 200 basis points.
"We were at 5.5 percent before the crisis, now we are at 11 percent, but in reality it's [more] like 13 percent, so it's a more than a doubling."
As for liquidity, Bordenave reported that reserves of "immediate liquidity, available overnight" at BNP Paribas now stand at 300 billion euros, compared to 50 billion euros at the start of the crisis.
According to the EBA, Europe's banks now hold a total of 3.6 trillion euros of high quality liquid assets, equal to 16 percent of the sector's aggregate balance sheet.
"A huge amount of work has been done and today I think we can say that the banking system is much more secure than before the crisis," Bordenave said. The post-crisis regulation had therefore largely achieved its objectives, and financial stability had been greatly improved.
"But this came at a cost. It had a major adverse impact on the funding of the European economy, because in order to comply with these waves of regulation, banks had to restructure their balance sheets massively," he told the hearing.
Again taking his own bank as an example, he said that to meet the higher regulatory capital ratios, over 600 billion euros, equal to the entire balance sheet value of Fortis, which BNP Paribas bought at the end of 2008, had to be trimmed from its balance sheet, bringing it down to 1.9 trillion euros, back to the size it had been before the Fortis acquisition.
"So ... in order to comply with the regulation, it was the equivalent of suppressing a big bank like Fortis," said Bordenave, an outcome which he described as "extremely expressive of what happened in the banking industry in Europe".
Europe's banking sector as a whole reduced total assets by a fifth between 2008 and 2013, he told the hearing.
"At the moment, virtually every bank has something for sale ... but there are not that many buyers."
This reduction in assets was partly achieved by a contraction of 520 billion euros in lending in the euro area between 2011 and 2015. However this proved insufficient to achieve the required asset shrinking, and so all banks had also run down their trading inventories, which were "a nice target in order to reduce banks' balance sheets without harming clients too much", Bordenave said.
"BNP Paribas and most of our investment banking peers [have been] obliged to reduce their inventories," he told the hearing. For example, one of the most liquid markets, sovereign bonds, had declined by 20 percent over the last three years, he told the hearing.