“Regulation And The Future Of International Banking”

The theme of this year’s World Economic Forum on Africa is “Achieving Inclusive Growth”. This is part of the response by global leaders to the urgent need to reduce inequality and increase inclusion in the international economy. The centrality of the banking sector to economic activity makes this a particularly important theme.

This year’s theme provides an opportunity to reflect upon the profound financial sector policy and regulatory changes put in place since then and what they mean for the future. There is no argument that better regulation of financial institutions was needed. Once the extent of the crisis became known it was clear that there had been reckless lending, as well as a proliferation of investment products whose risk profile was not understood by the banks, regulators, rating agencies and the insurance companies that were underwriting them.

Financial stability moved to the top of the agenda and regulators were given more powers to effect tangible change. Arguably the biggest factor impacting the industry was the Basel Committee’s requirement for banks to hold more capital of higher quality.

The costs of complying with Basel III requirements are significant. According to the Wall Street Journal, in 2013, the six largest US banks spent an estimated $70.2 billion on regulatory compliance, double, the $34.7 billion they spent in 2007. These costs have an implication for bank customers in the form of fees, as they need to be covered by income.

Not only did the cost of conducting business rise in line with increased regulation, but banks are now incurring large penalties for misconduct.

In response, global banks have reduced total assets, including derivatives, securitised mortgages and other securities, and have shed non-core businesses as they look to strengthen their capital and liquidity positions, reduce risk, and restore profitability.

Banks are less vulnerable and are better capitalised, which is positive – but the collateral impact has brought the future of global banking into question. If regulatory reform continues to follow the trajectory we have seen so far, there will soon be no banks that are truly global.

However, increasing global connectedness means there is a growing need for banks around the world to remain connected through “Correspondent Banking” relationships. These relationships enable the provision of cross-border payments and play an important role in facilitating trade and in the transfer of remittances from abroad. This is very common in Africa where many family income providers live and work outside their own country.

However policymakers are also introducing and tightening measures to stop the illicit flow of funds for the purposes of avoiding tax, money laundering, terrorism and other crimes. These rules are starting to lead to a decline in correspondent banking. According to an IMF discussion note published in June, Africa is among the emerging market regions worst affected by the decline in correspondent banking. It says it is mostly small and medium-sized exporters as well as small and medium-sized domestic banks that have been most affected by the withdrawal of correspondent banking relationships. Angola, Liberia and Guinea are among countries in Africa that have been hardest hit by this trend.

With the decline in correspondent banking, regional banks in Africa are vital to ensure the continued connectedness of the continent to the global economy. Regional banks are also necessary to effectively and efficiently facilitate intra-continental trade and finance infrastructure development on the continent. Regional banks have become the largest participants in new syndicates and large bilateral loans to finance infrastructure, according to a 2015 European Investment Bank report on Trends in Banking in sub-Saharan Africa.

However, I believe regional banks themselves are at risk.

Firstly, just as some banks are classified as globally systemic, we will likely see some of the regional banks being viewed as too big to fail in their region. This means that they too will face higher capital requirements, raising costs.

Secondly, regulations are not consistently implemented, and regional banks will often operate out of jurisdictions which have higher regulatory requirements. For example, South African-based banks have to comply with Basel III not only in South Africa, but also in other markets in which they operate, even if those markets have lower regulatory and capital requirements. Again, this has a significant cost impact for regional banks.

And thirdly, local regulators or policymakers’ actions and requirements may affect how regional banks are able to operate and grow. For example, some countries may require that the local operations of a regional bank are ring-fenced from operations in other geographies in an effort to prevent contagion and ensure sustainability.

There are other complications too. Global anti-money laundering requirements can pit regional banks in some parts of the world against jurisdictions where the political, legislative and judicial systems are weak. This can affect their ability to transact internationally, even after making the required investments in compliance. If the current regulatory-reform trajectory continues and regional banking operations, like global banks, are curtailed, then the logical conclusion is that domestic banks will be the survivors.

A trend to multiple domestic banks potentially means more competition, better products and cost advantages for consumers. However, there are a number of forces that will probably lead to the need for domestic banks to consolidate including:

  • That these banks will be systemically important in their own   countries which means the need for regulation and rising costs
  • Regulators are unlikely to have the capacity to regulate too many   banks, and
  • Banks from other countries will find it difficult to maintain relationships with too many local banks

There is no doubt that the key reasons for enhanced global regulation of the financial sector are well-intentioned and that many banks have become more resilient as a result – painful as the process might have been.

But it is important to ensure that stakeholders consider the likely end state of the industry. If the outcome is one that is unlikely to benefit the consumers in Africa and the rest of the developing world, then we have to consider a new set of changes that find equilibrium between managing systemic risk and allowing banking to responsively facilitate economic activity.