Banking Regulation 2023

Banking Regulation

2022 saw the banking industry continue to adjust to a changing world. The rise of geopolitical risk, deglobalisation and inflation pose challenges for a sector that has grown used to easy money derived from quantitative easing. A new generation of indebted borrowers is discovering the dangers of inflation and rising interest rates, in many cases compounded by the energy crisis resulting from the invasion of Ukraine.

Winter is coming

The economic fallout of the COVID-19 crisis was managed highly successfully by governments in most developed nations. Liquidity constraints were met by unprecedented public sector support – which served as a palliative to the immediate crisis, but also resulted in massive increases in sovereign debt. These actions have sowed the seeds of the current inflationary environment and the deleveraging that will inevitably need to follow.

Starting from stronger balance sheets than in 2009, and largely cushioned from the immediate effects by the actions taken by regulators, banks came through the COVID-19 crisis relatively unscathed, and the wave of governmental support deferred – if not eliminated – the wave of restructurings and liquidations that might otherwise have occurred.

Challenging times lay ahead, though. Rising inflation and, with it, interest rates have curtailed government support and will exacerbate solvency difficulties for heavily indebted borrowers in the corporate and retail sectors. Governments and central banks will be walking a tightrope over the next few years to return the role of financing to the market without triggering a debt crisis.

Restructurings

In the banking sector, an increase in the level of defaults is inevitable. The combination of higher interest rates and energy costs will be the immediate catalyst for many restructurings. In 2023 and beyond, a wave of corporate failures and personal bankruptcies will emerge. Pressure on banks’ restructuring capacity is likely to grow as responsibility for financing, and with it for work-outs, is passed back to the private sector. Banks will need to prepare to deal with that wave at scale, whilst maintaining appropriate controls to ensure the fair treatment of their customers. Mechanisms to clean up non-performing assets will likely also remain important: private credit providers, which are increasingly prominent in the market, will have a major part to play here.

Regulators will expect firms to have learnt the lessons of past foreclosure and restructuring scandals. Furthermore, the exercise of lenders’ rights against real economy participants – particularly individuals and SMEs – will be highly politically sensitive. That sensitivity is likely to make itself felt through continued barriers to the enforcement of lenders’ rights – be they legislative, regulatory (moratoria, and also conduct-derived impediments to rapid workouts) or reputational. In this environment, reconciling banks’ prudential and conduct obligations may become increasingly challenging.

Prudence, provisioning and prudential regulation

Banks have entered this new phase with strong balance sheets (in part due to the post-crisis Basel reforms). They will benefit from a welcome resurgence in net interest income, but will also need to look to make provisions to prepare for a wave of defaults, and may be targets for windfall taxes to fund government deficits. As incoming recession bites, banks will also feel the scrutiny of investors and rating agencies, which will want to understand banks’ assessments of impairments and will view regulatory ratios with greater scepticism.

Bank regulation becomes political in a recession.

Depending on the depth of any recession, the current wave of Basel Accord implementation (currently scheduled for 2025 in the UK and Europe) may be deferred.

In the UK, a housing crisis may also cast doubt over the prudence of ring-fencing measures, which have forced UK retail banks to recycle deposits into UK-situs mortgage and consumer debt.

The re-emergence of the doom loop

The price tag for the pandemic has been paid largely by sovereigns. In the longer term, banks (particularly EU banks) are at risk from the re-emergence of the bank-sovereign doom loop that caused stress in various Southern European member states. Banks can do little to manage this risk, but it will need to be factored into planning for the medium term.

Deglobalisation and fragmentation

In light of geopolitical events, globalisation feels to be in abeyance, if not full retreat. Following many banks’ exit from Russia, continued tensions between the East and West may put similar pressures on banks that are active in China and the West. For international banks, the increased polarisation of the world is generally felt through regulatory fragmentation. International standard setters tend to be less influential in times of low international political consensus, and regulatory fragmentation increases.

Future challenges

ESG and technology remain the two greatest areas of future challenge for the sector. Europe has led on the creation of a regulatory framework for ESG, with the UK following behind and the US a fair distance behind. Progress has been slowed by the energy crisis, but will continue. Banks will need to build out their governance, risk management, disclosure and product level expertise in ESG, and navigate the pitfalls around greenwashing and compliance.

Focus on banks’ technology platforms is also likely to continue, via incoming standards on operational resilience and cloud providers. Governments and regulators are likely to focus ever closer on the oligopoly of major IT providers to the financial sector, given their increased concentration and the ever greater risks their failure would pose to the financial system.