PricewaterhouseCoopers has published a monster of a report, “Impact of bank structural reforms in Europe,” sponsored by the Association for Financial Markets in Europe (AFME). This beast is a big picture of how bank reforms will affect banks themselves, financial markets, end-users and the EU economy. Needless to say, costs will go up, liquidity will go down, and costs are greater than benefits. There is a lot in this report that is basic info but there are also some analyses of how banks and markets will likely react to upcoming changes.
The most interesting parts of the report to us centered on ring-fencing and liquidity. For a ring-fenced capital markets unit of a bank, PwC found that “the markets entities of EU banks will be small in relation to the size of the universal banks of which they are currently a part.” As newly separate companies, separated markets entities should expect to see credit downgrades of 1-5 notches and increased funding costs of between 35-138 bps. That’s a phenomenally high new cost especially in the current interest rate environment. There is always a need for a suspension of disbelief in any analyst projections, but any number even close to 30, 50 bps or higher is a standout. It’s not a surprise per se, but rather a clarification that separating out capital markets units from retail carries a weighty cost to those organizations and their clients.
We’ve been paying a lot of attention to fixed income liquidity lately, and the PwC study notes that nine banks’ FICC businesses could become immediately “commercially unviable” following a major restructuring, out of 18 banks analyzed. That would be a sharp loss in market liquidity. Part of the report features an econometric study that shows the relationship between the number of market makers in a security and the liquidity risk premia. Liquid corporate bonds have around 13 market makers while less liquid bonds have only 5. The sharp drop off in liquidity comes with under 7. If all of the sudden nine banks pulled out of corporate bond market making, that could have a very disproportionate impact on overall corporate bond liquidity.
For the quants among us, the liquidity study looked at 745 investment grade corporate bonds across four different time periods, for a total of some 3,000 observations. The model used only vanilla corporate bonds with a consistent trading history.
In positive news, the study sees investment banking revenues rising by 10%. This is the result of a protected market “where there are few alternatives to banks.” This raises an interesting question, in where else are there few alternatives to banks? Banks are increasingly competing with alternative actors (SME online lending, hedge funds in Shadow Banking, Direct Repo, CCPs opening up to the buy-side, CSDs reaching into custody) and it is a legitimate question to ask where the strategic defenses are. What is bank business that can’t easily be replicated elsewhere?
The full report is available from AFME’s website here.