REGULATION, CASH MANAGEMENT
Covid-19: Financial regulatory responses
22 April 2020
As sectors across the economy attempt to bolster their resilience against the Covid-19 pandemic, regulators have been playing their part in keeping the wheels turning. flow’s Janet Du Chenne assesses how postponing significant financial regulatory change bodes well for business and how fiscal and macroprudential measures can best enable banks to facilitate a return to growth
Anyone seeking proof that crisis breeds creativity need only look at the response across sectors of the economy to mitigate the impact of the Covid-19 pandemic. Take for example the creation of 30,000 new jobs by supermarkets in the UK1, Virgin Media’s offer of free entertainment channels2, and free online tours of many museums and art galleries3. Elsewhere in the economy, corporates have encouraged creative-problem solving for their own unique challenges.
Business continuity, the well-being of their employees, the disruption of supply chains, weakened customer demand (see Figure 1) and potential revenue delays make up one set of challenges. Securing liquidity and adequate credit to ensure the continuation of businesses is another. Given uncertainties around the duration and extent of the sharp economic slowdown, priority tasks include ensuring sufficient cash flows for business-critical outgoings, as well as interest payments for existing loans, and the ability to draw down already available credit facilities. At the same time, it is stressed that these measures are in response to a crisis and the intention is for them to be only temporary until a more normal business environment returns.
Figure 1: Impact of pandemics on supply chains
Many governments have passed fiscal measures designed to facilitate lending to these firms. While this action has bridged partnerships between central banks and commercial banks to get the support from packages through, the impact on long-term indebtedness raises concerns for future GDP growth.
Amidst all of these measures4, their impact on the economy should be weighed against plans for eventual recovery. In flow’s recent report Towards a silver lining analysts are already assessing the impact and cost of what could be around US$5trn in fiscal support, while economies are taking lessons from the global financial crisis on how to emerge fitter for business post-pandemic5.
In the same way that the flow article Central banks – onside or outside assessed the effectiveness of sharp interest rate cuts with massive quantitative easing programmes and questioned whether central banks and monetary policy intervention aren’t simply creating bigger problems for the future, fiscal policy and regulatory measures should be viewed through a similar lens. Their implementation requires close co-ordination to ensure that market infrastructures remain stable and that loans and guarantees can help economies emerge from Covid-19 without a huge debt burden stinting their growth. Furthermore, any adjustments should not undermine the long-run credibility of financial policies and for this reason be seen to be temporary.
Delaying capital markets regulatory change
To protect stability in market infrastructure and ease the pressure on the financial sector, regulators have postponed implementation dates for wide-ranging banking and capital markets regulations.
For derivatives, the Basel Committee on Banking Supervision and International Organization of Securities Commissions (BCBS IOSCO) have delayed the implementation of the fifth wave of initial margin rules for uncleared derivatives, or uncleared margin requirements for firms, putting both the two-stage deadlines back by 12 months.
The European Securities Markets Authority (ESMA) has extended the consultation response date for Markets in Financial Instruments Directive (MiFID II)6 to 18 May 2020. In addition, the regulator also delayed the Securities Finance Transaction Reporting (SFTR) regulation, initially scheduled for the 11 April 2020, to 13 July 20207.
Freeing up banks to lend
Banks face deadlines for meeting certain liquidity and capital requirements, and thus delaying those timelines enables them to focus on extending their support at a time when they face an unprecedented demand for liquidity. To give banks and supervisors more time to respond to the immediate financial stability priorities arising from Covid-19, BCBS IOSCO has delayed the implementation on the Basel IV standards by one year.
As noted in Koen Holdtgrefe’s recent flow article, Heavyweight Assets?, the Basel prudential regulatory package has standards prescribing how much capital and liquidity banks need to hold against all their exposures. The first Basel framework was published in 1988 and, via multiple reviews, the fourth version (Basel IV) will be adopted in Europe over the next couple of years.
With this latest version, the framework for how banks calculate the amount of capital they need to hold against each exposure is completely overhauled. One of the biggest changes comes from the introduction of the output floor. This will lead to banks focusing more on the use of the standardised approach when calculating their risk-weighted assets (RWAs) instead of applying internal models. Any increase in RWAs would directly impact their clients in terms of pricing and availability of funding.
However, delaying the implementation date of the Basel IV means some reprieve. As part of the BCBC’s measures, the final Basel III (Basel IV) accompanying transitional arrangements for the output floor have also been extended by one year to 1 January 2028.
Implementing fiscal and macroprudential measures
Regulators and governments have introduced a broad range of support measures for both businesses and individuals affected by the payment difficulties and liquidity shortages as a result of the Covid-19 pandemic (see Figure 2). This includes some relaxation of the prudential regulation measures for banks.
Figure 2: Policy measures by governments and regulators
Compromising the policies excessively in the short run can create serious long-term damage.
Under these prudential requirements, banks are mandated to control risks and hold adequate capital as defined by capital requirements, liquidity requirements, by the imposition of concentration risk (or large exposures) limits, and by related reporting and public disclosure requirements. By delaying the implementation of certain regulations and recalibrating them, this frees up banks to focus on providing support to the economy, including the use of buffers to maintain the flow of liquidity for corporates.
Key regulators such as the European Central Bank (ECB) and the US Federal Reserve Bank have issued guidance on how they see these being implanted between national authorities and banks. These include full use of capital and liquidity buffers (see Figure 1), including Pillar 2 Guidance and relief in the composition of capital for Pillar 2 Requirements.
On the ECB’s direction, macroprudential policy actions by several euro area authorities8 (including central banks and banking supervisors) have reduced capital requirements, including the countercyclical capital buffer (CCyB) and other macroprudential buffers. The overall impact of these measures will be to free up more than €20bn of Common Equity Tier 1 capital held by euro area banks, thereby facilitating the absorption of losses and supporting the provision of credit to the economy. These macroprudential actions complement and reinforce the measures announced by ECB Banking Supervision since 12 March 2020, including requesting banks to not pay dividends or buy back shares during the pandemic9.
The Bank of England has also acted by reducing the UK countercyclical capital buffer rate to 0% of banks’ exposures to UK borrowers with immediate effect for an expected 12 months. The BoE, issued guidance to UK banks regarding the measures firms should be taking to support businesses and consumers during the ongoing COVID-19 outbreak, namely through the implementation of the COVID Corporate Financing Facility (CCFF) and the Coronavirus Business Interruption Loan Scheme (CBILS).10 The CCFF11, which has a lifespan of at least 12 months, will buy short-term debt from larger companies, which are fundamentally strong, but have been affected by a short-term funding squeeze. Another BoE initiative, the Contingent Term Repo Facility (CTRF) allows participants to borrow central bank reserves (cash) against specified collateral for three months12.
In the US, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) contains several provisions that contemplate financing programs to be administered by the Treasury Department or the Federal Reserve. The act has a provision for a US$2trn fiscal package including a new US$500bn fiscal package to help assist and guarantee loans to companies and US$350bn to help small businesses. The Fed announced programmes intended to provide liquidity to businesses and has set out conditions13. Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance will provide bridge financing for up to four years, a Secondary Market Corporate Credit Facility (SMCCF) will lend, on a recourse basis, to an SPV that will purchase corporate debt issued by eligible issuers in the secondary market, and a Term Asset-Backed Securities Loan Facility (TALF) is intended to facilitate the issuance by private entities of asset-backed securities (ABS).
In a another move, to facilitate the offering of Paycheck Protection Program loans to small businesses, the Fed lifted asset caps on lenders including a US$1.95trn asset cap it had imposed on Wells Fargo in 2018. The regulator is adopting this interim rule to allow banking organisations to neutralise the regulatory capital effects of participating in this facility.
In Asia, key regulators such as the Monetary Authority of Singapore (MAS) launched regulatory and support measures designed to help banks focus on supporting customers14. Its guidance includes the adjustment of banks’ capital and liquidity requirements, to help sustain their lending activities.
The regulator encourages banks to use their capital and liquidity buffers “as appropriate” to support their lending activities and not to use the releases of these buffers to finance share buybacks during this period. Allowing banks to recognise as capital more of their regulatory loss allowance reserves will help to enhance banks’ capacity to lend. The relief will apply until 30 September 2021, and may be extended if necessary.
Joint action is key
A co-ordinated approach to monitoring, diagnosing emerging strains and taking regulatory action would yield much more positive results than disjointed and inconsistent responses
The various actions by key central banks brings the importance of partnership to fore. Co-ordination between central banks and banks to lend without risking the stability and transparency of the financial system will be important to how these measures work in practice. The message from BIS in Reflections on regulatory responses to the Covid-19 pandemic15 (April 2020) is loud and clear. “Adjustments should not undermine the long-run credibility of financial policies. Credibility is hard to gain and easy to lose. Compromising the policies excessively in the short run can create serious long-term damage. From this perspective, adjustments should be, and seen to be, temporary. Transparency is key in meeting this principle.”
BIS suggests central banks be guided by three principles when making the adjustments.
- the adjustments should be effective in supporting economic activity now and even beyond when establishing the basis for solid recovery that should preserve the health of the banking, financial system;
- banks should remain sufficiently well capitalised, liquid and profitable to underpin sustainable growth;
- the adjustments should not compromise the long run credibility of financial policies. From this perspective adjustments should be seen to be temporary.
Despite regulators’ explicit recommendations to use the buffers, banks may need to be confident that deadlines for rebuilding them will be sufficiently flexible and consistent with the normalisation of economic activity and capital markets. So greater clarity would help, said BIS. It suggested that one way of mitigating some of these disincentives to use their buffers is to include blanket distribution restrictions and related to the size of the buffer.
In acknowledging that the crisis poses a threat to financial stability16, the IMF also notes fiscal policy has a vital role to play in getting liquidity to large parts of the global economy that have come to a standstill. Close, continuous international coordination will be essential to support vulnerable countries, to restore market confidence, and to contain financial stability risks. It notes that to date, central banks have announced plans to expand their provision of liquidity—including through loans and asset purchases—by at least US$$6trn and have indicated a readiness to do more if conditions warrant. In its Global Financial Stability Report the IMF says that governments have to do whatever it takes, while adding “But they must make sure to keep the receipts17”.
The OECD also noted that the economic dislocation caused by the Covid-19 crisis is hitting the functioning of financial markets, and called for joint actions on a global scale to win the war18. It acknowledged that central banks have already launched bold actions to support the economy but financial regulation and supervision is another area where co-ordination could produce better outcomes. “A co-ordinated approach to monitoring, diagnosing emerging strains and taking regulatory action would yield much more positive results than disjointed and inconsistent responses,” it said.
More to come
While existing regulatory timelines for banks are postponed and fiscal policy is being implemented, new regulatory initiatives that could help guide the economy back to a new normal are being assessed.
Recognising that the infection risk will likely accelerate the push towards digital payment systems across the world, many regions are taking steps to regulate the introduction of digital and cashless pay initiatives. This has spurred the European Commission to press ahead with a new five-year “Digital Finance Strategy” to follow its 2018 Fintech Action plan, and to the EU's first “Retail Payments Strategy". The Commission is seeking input on both of these strategies for regulating digital finance from incumbent and new financial players alike until 26 June 202019. In a separate consultation, the financial services board is seeking consultations on regulating stablecoins20.
Linked to these digital initiatives, the Commission is also seeking input on digital sustainable finance as it continues to pursue a green growth strategy. The strategy will provide a roadmap with new actions to increase private investment in sustainable projects and activities to support the different actions set out in the European Green Deal and to manage and integrate climate and environmental risks into the financial system. The initiative will also provide additional enabling frameworks for the European Green Deal Investment Plan.
The Commission’s consultation on a renewed sustainable finance strategy will remain open until 15 July 2020. It wants to ensure that technological innovations such as AI and machine learning can help to better identify and assess to what extent a company's activities, a large equity portfolio, or a bank's assets are sustainable. It also believes the application of Blockchain and the Internet of Things may allow for increased transparency and accountability in sustainable finance.
In the US, the fourth coronavirus stimulus package under consideration could see a reduction of taxes on capital gains taxes on cryptocurrencies. If passed, and capital gains are allowed cost basis indexing, according to a Forbes21 analysis "this new approach could help stimulate the economy by helping individuals keep more investment income in their pockets and rectify the long-standing inflation gap in calculating capital gains taxes."
This article includes inputs from the following regulatory experts:
Polina Evstifeeva, Head of Regulatory Strategy, Deutsche Bank Corporate Bank
Emma Johnson, Securities Services, Market Advocacy, Deutsche Bank Corporate Bank
Koen Holdtgrefe, Head of Prudential Regulatory Affairs, Deutsche Bank
1 See https://bit.ly/2KjluFM at personneltoday.com
2 See https://bit.ly/3NfqmLs at advanced-television.com
3 See https://bit.ly/3cB5lYb at rd.com
4 See https://bit.ly/34SCnR2 at deutschewealth.com
5 See Towards a silver lining at flow.db.com
6 See https://bit.ly/34SsLWx at esma.europa.eu
7 See https://bit.ly/36zLdrN at securitieslendingtimes.com
8 See https://bit.ly/2Vrf5P6 at ecb.europa.eu
9 See https://bit.ly/2RVAopT at bankingsupervision.europa.eu
10 See https://bit.ly/2wVBF92 at gov.uk
11 See https://bit.ly/3auRSzM at bankofengland.co.uk
12 See https://bit.ly/2yAlHBW at bankofengland.co.uk
13 See https://bit.ly/34U5K5q at bakermckenzie.com
14 See https://bit.ly/2Vte6Oy at mas.gov.sg
15 See https://bit.ly/3czlLjU at bis.org
16 See https://bit.ly/2XUa9DS at blogs.imf.org
17 See https://bit.ly/2VOSOJQ at blogs.imf.org
18 See https://bit.ly/3cCtGgu at read.oecd-ilibrary.org
19 See https://bit.ly/3bnpalE at lpscdn.linklaters.com
20 See https://bit.ly/2Km4vm9 at fsb.org
21 See https://bit.ly/3czWcix at forbes.com
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