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SUMMARY REPORT

RECONCILING REGULATION AND GROWTH 3RD JOINT ANNUAL OLIVER WYMAN & CIGI CONFERENCE

INTRODUCTION

This report summarizes the discussions from the third joint annual conference by

Oliver Wyman and the Centre for International Governance Innovation (CIGI), which took

place in Rome. Since 2014, Oliver Wyman and CIGI have partnered to bring together

senior bankers, policymakers, regulators, supervisors, and academics from across Europe

to debate the most important topics in the financial services industry. The annual joint

conferences are instructive, informative forums where the private and public sectors can

connect and share ideas.

The international financial crisis of 2007-09 prompted a new era in thinking about financial

regulation, which transformed our understanding of risk management and financial

stability. The subsequent eurozone crisis reinforced the view that the European financial

system remains vulnerable without a common fiscal backstop and better supervision

and regulation.

In 2016, the third annual conference focused on how to reconcile regulation and growth in

Europe’s financial services industry. Participants explored the channels through which the

new European regulatory framework could help create a basis for stable economic growth.

This report highlights some of the ideas that emerged by summarizing four themes

discussed at the conference. The conference was held under the Chatham House Rule,

according to which neither the name nor affiliation of speakers can be attributed to any

comments. Oliver Wyman and CIGI would like to thank the distinguished group of speakers

and the more than 100 delegates who contributed.

Copyright © 2017 Oliver Wyman 1

CONFERENCE SPEAKERS

IGNAZIO ANGELONI European Central Bank, Member of the Supervisory Board

PETER BESHAR Executive Vice President and General Counsel, Marsh & McLennan Companies

DOUGLAS ELLIOTT Partner, Oliver Wyman

ANDREA ENRIA Chairman, European Banking Authority

PAOLO GARONNA Secretary General, Italian Banking, Insurance and Finance Federation

MAURO GRANDE Director of Strategy and Policy Coordination, Single Resolution Board

JOSÉ MANUEL GONZÁLEZ-PARAMO Executive Board Member, BBVA

MALCOLM KNIGHT Distinguished Fellow, CIGI

REZA MOGHADAM Vice Chairman for Global Capital Markets, Morgan Stanley

MICHEL PÉBEREAU President, MJP Conseil

KLAUS REGLING Chief Executive Officer, European Financial Stability Facility and Managing Director,

European Stability Mechanism

SIR HECTOR SANTS Partner and Vice Chairman, Oliver Wyman

NICOLAS VÉRON Senior Fellow, Bruegel and Visiting Fellow, Peterson Institute for International Economics

MIRANDA XAFA Senior Fellow, CIGI

MARK YALLOP Chair, FICC Markets Standards Board


RECONCILING REGULATION AND GROWTH

HIGHER CAPITAL REQUIREMENTS SHOULD NOT REDUCE LENDING

After the 2008 financial crisis, Basel and other

regulations demanded that banks hold greater levels of

capital and liquidity to make them more robust in the

face of financial shocks: The funds would act as a buffer

in absorbing any future shock, keeping the banks out

of danger. “It is by now generally recognized that it was

a crisis of bad regulation and under-regulation,” said

one attendee.

The trouble would be if higher capital requirements led

to a decrease in bank lending, thus slowing economic

growth. The effect is a concern especially in Europe,

because businesses there depend on bank financing

far more than those in the United States, where direct

financing is more common.

However, there’s an upside. Greater equity makes a

bank less risky, reducing its debt and equity costs. Two

economists, F. Modigliani and M.H. Miller, won Nobel

Prizes showing that the costs of higher capital levels

would be completely offset by a lower price for capital

thanks to greater safety. Whether or not this works

in real life is one of the central questions for financial

regulation now.

There was widespread agreement after the crisis that

capital and liquidity requirements needed to rise

substantially. But if these requirements come with

excessive costs, then the overall economic impact

might be negative. “In an ideal world, it would mean

we could raise capital levels much higher and have

therefore a much safer system without an actual

increase in cost,” in the words of one participant.

“Unfortunately, it’s also very clear that in the real world

this Modigliani-Miller effect only works part way.” If a

bank’s safety is seriously in doubt, then higher capital

requirements will be beneficial, said the participant.

However, if large banks are already at a point where

they’re considered unlikely to fail, then the benefits of

higher capital will be less, “and what you are left with


is a series of inefficiencies we know exist in the market,

such as tax effects that make debt less expensive than

funding yourself with equity,” he said. That would mean

banks’ customers do not benefit from the improved

safety as much as might otherwise be expected.

There’s evidence from a number of studies – both

academic and official – that higher capital requirements

have a negative impact on bank lending. The average

estimated impact of each percentage-point increase

in required capital ratios is 2.6 percent. So, given that

capital ratios have gone up by five percentage points or

more, the requirements could have reduced lending by

13 percent or so. “That feels a bit high to me but I don’t

know how to tell,” said one panelist. “We don’t have

the counterfactual of what lending would have been

without these changes. But I have talked to people even

in the official sector who think that estimate might not

be wildly off.”

However, there may be a time lag between the

introduction of new regulations and their beneficial

effect. Therefore, it’s important to distinguish between

the impact at the time the new rules are introduced,

and the long-term effect after a steady state has been

reached. Studies show that, in the short term, funding

costs do increase, impacting lending rates, growth in

lending, and banks’ ability to provide market-making

services. But there is also evidence that banks that

have strengthened their capital positions faster in

the aftermath of the recent financial crisis are also

now lending more in the real economy than banks

that have only slowly undertaken the process of

recapitalisation. “Some systems have used public

support to impose strict conditionality and press

ahead quickly with adjustments in business model

and bank restructuring,” according to one speaker.

“These are the systems where lending growth has

recovered fastest.”

“In an ideal world, it would

mean we could raise capital

levels much higher and

have therefore a much safer

system without an actual

increase in cost”



RISK IN THE GLOBAL FINANCIAL SYSTEM: THE EUROPEAN ANGLE

The financial crisis pointed to a need for

macroprudential measures to avoid a repeat of

the subsequent economic shock and to spare

taxpayers from future bills for bailing out financial

institutions. However, current market structures and

supervisory arrangements are not yet in optimum

shape. Politicians, central banks, and international

organizations therefore need to think about how risk

can be better managed and about the institutions

needed to oversee such an effort.

Several factors contribute to risk in the international

financial system. One is the amount of leverage in the

system – whether enough capital is supporting the

vast superstructure of financial assets. Another is the

complexity of instruments, hedging strategies and

risk management. A third is the interconnectedness of

finance across geographical and sectoral boundaries,

which produces systemic interdependence, entailing a

corresponding systemic risk.

However, these structures cannot be dismantled.

Interdependence of economic actors is the basis of

economic activity and wealth creation. Reducing

interdependence might reduce systemic risks: Markets

could be fragmented, capital controls introduced,

barriers erected to the mobility of resources, and trade

restrictions introduced. “That in some ways would be

quite easy,” said a participant. “You probably have less

risk. But is this risk reduction? Is this stability? Or is this

rather stagnation, a road to stagnation?”

The euro area, in particular, could reduce risk through

greater risk sharing. There are three main channels

for risk sharing. The most effective is through wide,

deep, and liquid capital markets. The next best stems

from free-flowing credit allocations through bank

intermediation. The third is through fiscal safety nets.

The trouble is, these have so far been activated in the

wrong order. The first to be used was government

bailouts – huge sums of public money that in some

cases created public deficit and debt problems.

These bailouts also brought with them moral hazard,

implications for market discipline, and the loop of

bank debt and sovereign debt. Next came excessive

leverage in the form of an expansion of banks’

balance sheets. Finally, little effort has been made to

improve risk sharing through capital markets, which

are still fragmented in the eurozone. “Risk sharing

is underdeveloped in the euro area, and the capital

markets channel is underdeveloped in particular,”

said one attendee. “In the US, shocks are evened out

more than twice as much as in the euro area. Even

inside large countries such as Germany and France,

risk sharing is much better developed than across the

euro area.”

Capital markets need to be developed in a way that

lets these channels be activated in a different order,

commented one attendee. “I think the rebalancing

which is in the title of this conference, probably should

start also from the reordering of our priorities in terms

of the channels to have better sharing and reduction of

risks,” he said.

Interconnectedness also means thinking about the

interaction of market participants with different risk

profiles. While some connections act as amplifiers of

stress, others can be shock absorbers. For example,

if highly leveraged institutions lose funding and

have to sell assets, these can be bought at low

“We need some people thinking about

global balances at the level of the

world economy, it was necessary 10

years ago; it’s still necessary today.

Macro-prudential is an issue of

monetary policies and fiscal policies.

That is to say, it is an issue of global

economic mismatches”


prices by an insurance company or sovereign wealth

fund – institutions with a long-term time horizon, little

leverage, and lots of cash flow.

Identifying these patterns in the financial system are

the responsibility of a macroprudential regulator,

whose first job is to identify emerging vulnerabilities in

the financial system. The United Kingdom’s Financial

Policy Committee is regarded as a good system.

Other countries with integrated, universal banking

systems – such as Canada, Australia, and to some

degree France – also have had domestic procedures

for monitoring systemic risks and implementing

macroprudential regulation for a long time. “Without

maybe a clear mandate, they’ve actually worked fairly

well,” in the words of one speaker.

The original question of macroprudential policy – of

preventing another financial crisis – can be split into

two. First, will the new structures and oversight prevent

a repeat of the last crisis? Here, good progress has been

made. “If you think about the ‘never-again’ of the past,

it doesn’t look too bad,” said one of the participants.

“I don’t think it’s perfect. But if you think about the

bottom-up process in terms of individual prudential

regulations, individual prudential supervision, and

individual oversight structures in the EU, we all know

that tremendous progress has been made.”

But the second question is whether another kind of

crisis could happen. Here things don’t look so good.

“Never-again for the future’ looks pretty iffy,” said

the participant. “If you define financial stability and a

financial stability framework as one that is meant to

be addressing any risk that can generate instability,

we don’t have that framework and we’re not thinking

enough about all the risks in those categories.

Secondly, if in order to solve those sorts of problems

you need an integrated response framework which

crosses between regulators, supervisors, central banks,

and governments, then we’re not integrated in that

fashion, even in Europe, let alone globally. Thirdly, if

a response framework needs to have as many shock

absorbers as possible, clearly we don’t have a fully-

functioning and well-developed capital market in

the EU.”

In particular, the Financial Stability Board (FSB) was set

up to work on global macroprudential policy, but it has

not done this in the opinion of one participant. Instead,

it has focused on banks, a micro-prudential task. So,

there’s a need for institutions – such as the FSB and

central banks – to figure out ways to fill the gaps. “We

need some people thinking about global balances at

the level of the world economy,” said the participant. “It

was necessary 10 years ago; it’s still necessary today.

Macro-prudential is an issue of monetary policies and

fiscal policies. That is to say, it is an issue of global

economic mismatches,” in the view of this participant.



FILLING THE GAP BETWEEN RULES AND ETHICS

Misconduct is a pressing problem for the financial

industry. Over the last five years, banks have

paid – or reserved funds for – about $375 billion in fines

worldwide. If that money had been retained as capital

rather than paid out in fines to regulators, it would

have supported up to $5 trillion of lending capacity,

according to a Bank of England estimate.

As authorities strive to create an environment that

minimizes the likelihood of wrongdoing, one of the

challenges is that conduct measures tend to belong to

one of two categories: high-level principles and hard

rules. The high-level principles dictate statements such

as “always act with integrity” and “treat your customers

fairly.” The trouble with these are that they are vague.

They provide a basis on which to consider whether a

particular action is correct or not – but they are not a

guide that can help provide a quick answer for a trader

with a dilemma.

For that, explicit, concrete rules are more helpful – a

compendium of operational procedures to follow.

Regulators tend to find these a straightforward way

to act against misconduct. “To a hammer, everything

looks like a nail,” said one attendee. “So, there is a

popular viewpoint in regulatory circles that the solution

to misconduct is very simple. We need to pass more

regulations; we need to write tougher laws; and we

need to lock more people up in prison.”

But, while much formal regulation is essential, it comes

with its own problems. It’s sometimes possible to get


around inconvenient rules using business-model or

geographical arbitrage, pushing certain operations out

of well-regulated fields or jurisdictions and into those

that are less well-regulated. Moreover, formal regulation

can undermine financial services workers’ sense of

personal responsibility for their actions; this needs to be

enhanced, not sidelined. Finally, the speed of innovation

in financial markets is such that even efficient, well-

organized regulators struggle to keep pace.

Most financial markets use both high principles and

detailed rules. The problem is that there is a void

between the two, as there is no clear reference point

or guard rail to indicate to firms how to operate on

a practical basis. For example, the United Kingdom

has no rules forbidding the concealment of positions,

on directing orders to favored counterparties, or

on the dividing line between hedging and market

manipulation. The void is compounded by other

factors, such as a fading collective memory of the

causes and consequences of the recent financial crisis

because of high staff turnover. Also, much policymaking

tends to be theoretical and not make enough use of

practical experience. “Surprisingly enough, human

nature and the shape of markets don’t change very

much over time,” commented one participant. “So

misbehaviors do repeat again and again and again.”

One approach to filling the void is London’s Fixed

Income, Currencies and Commodities (FICC) Markets

Standards Board. This brings together participants

from all sides of the markets, to formulate global

standards that tell people what to do in the regulatory

void. It consists at the moment of 38 firms that

represent more than 80 percent of all sell-side activity,

more than $10 trillion of assets under management,

and roughly half of European exchange volumes.

Since it started work in early 2016, it has published

five standards.

The Board has a motivation to keep going. If it fails to

do a good job, its conduct regulator will step in and

write several meters of new rules to plug any gaps that

it’s left.

The speed of innovation in financial

markets is such that even efficient,

well-organized regulators struggle to

keep pace.



IF BREXIT SHRINKS THE CITY, WHAT WILL BE THE IMPACT ON THE EU27?

It’s well known that the City of London will suffer if the

UK leaves the EU single market. Banks that are based in

London and operating in the European Economic Area

(EEA) might have to either exit those markets or turn

local branches into subsidiaries. Either way, that will

mean less business – and fewer jobs – for the City.

But a hard Brexit would also impact the rest of the EU,

because the EU27 are big customers for the financial

services currently delivered in London. “If you break

up the City infrastructure, yes, some activities may well

have to move in to the EU to enable that business to be

done within the EU,” said one panelist. “But it’s not a

question of shifting the whole of the City. What’s going

to happen is fragmentation.”

There will be at least two major effects. First, the resulting

fragmentation will cause declining efficiency and

higher costs. In some cases, banks will simply withdraw

capacity because of the cost pressure of fragmentation

on their business models. Instead of being transferred

from London to Paris or Dublin (or even New York), the

capacity will disappear. All this means that access to

financing for EU27 businesses will become harder and

more expensive. “Focusing on it as a game where you

move things around but nothing happens except there

are geographical winners and losers – that is going to be

the wrong way of looking at it,” said the panelist.

A second impact of Brexit will be to reframe the Capital

Markets Union (CMU), as this will no longer be centered

in London. As a result, the EU27 will need to undertake

deeper reforms than those so far envisaged for the

CMU. “The next big thing in EU reform should be how

to give ourselves the structures to properly supervise,

administer and enforce EU27 capital markets in areas

such as conduct and investor protection,” said one

speaker. “We can probably agree that our structures

right now are not up to standard.”

Brexit therefore presents the EU27 with an opportunity

to set up such structures, for example by reinforcing the

European Securities and Markets Authority (ESMA). If

approached correctly, the EU can be far more ambitious

in its financial markets development than originally

anticipated in the CMU.


“If you break up the City

infrastructure, yes, some

activities may well have

to move in to the EU to

enable that business to be

done within the EU, but it’s

not a question of shifting

the whole of the City.

What’s going to happen

is fragmentation.”


CONCLUSIONS

Regulators and politicians have focused on how to make sure there is no repeat of the

problems that caused the financial crisis. For bank regulation, that has meant higher capital

and liquidity requirements. Conduct authorities have drawn up new regulations to reduce

the likelihood of malpractice in the financial industry. And supervisory structures have

made progress on macroprudential risk.

These efforts have in large part been successful. However, they need to be augmented and

challenged with new ways of thinking about growth and risk. New possible dangers to the

global financial system need to be envisaged and prevented, as do new kinds of financial

misconduct. And, while a more robust banking sector is a good thing in itself, the impact of

higher capital requirements on growth needs serious consideration. Europe will also need

to deal with the financial fallout from Brexit, which looks likely to bring about fragmentation

in financial markets – and, therefore, higher costs.


Copyright © 2017 Oliver Wyman

All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect.

The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.

ABOUT OLIVER WYMAN

Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 26 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm’s 4,000 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC].

For more information, visit www.oliverwyman.com. Follow Oliver Wyman on Twitter @OliverWyman.

ABOUT CIGI

The Centre for International Governance Innovation (CIGI) is an independent, non-partisan think tank focused on international governance. Led by experienced practitioners and distinguished academic, CIGI supports research, forms networks, advances policy debate and generates ideas for multilateral governance improvements. Conducting an active agenda of research, events and publications, CIGI’s interdisciplinary work includes collaboration with policy, business and academic communities around the world.

CIGI’s research programs focus on: global economy, global security and politics and international law. The Global Economy Program address limitations in the way nations tackle shared economic challenges. In undertaking its research, the program leverages its comparative advantage in bridging the gap between economics and policy making.

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