Real-economy cost of regulation in the Swedish Banking System (2016)

Over the coming years, banks will need to comply with a swathe of new regulations concerning capital, leverage, liquidity and business conduct. As with Basel II, which preceded the financial crisis, and with the regulations introduced in its immediate aftermath, these new rules aim to make the financial system more stable and to protect taxpayers from the cost of bailing out insolvent banks. Such regulations also bring costs - in the first instance, for the regulated banks, but in the longer term, potentially also for banks’ customers and society more broadly. An assessment of proposed regulations must consider these costs, as well as the intended benefits.

Oliver Wyman was commissioned by the Swedish Bankers’ Association to write a report on the implications of financial regulations for the Swedish economy. We have conducted a review of relevant research, and interpreted the findings in the context of the Swedish market. The purpose of this paper is not to make recommendations, but to inform policymakers and analysts about the way pending financial regulations are likely to affect the real economy. We focus on the effects of the rules already recommended by the Basel Committee on Banking Supervision or Finansinspektionen (the Swedish FSA).

It is important to stress that our analysis is based on the best possible understanding of emerging regulations at the time of writing this report. Many of the regulations mentioned in this report are still being debated by regulatory bodies, and the final calibration has in many cases not yet been determined.

We conclude that:

The reforms are likely to increase banks’ cost of capital. Historically, the funding costs for banks have been reduced with increased capital requirements. However, this upside decreases the higher the capital requirements are. The additional costs for banks are likely to be passed on to the wider economy through higher prices for credit and reduced lending. This effect will not be uniform across classes of borrowers. Our analysis indicates that SMEs are likely to be hit especially hard.
Regulatory requirements may effectively replace internal and rating agency measures in banks’ capital allocation and pricing processes. Regulations now often demand more capital and liquidity than the quantities determined using other methodologies. This has implications for banks’ risk measurement practices, as the discrepancy between regulatory requirements and internal views of risk widen. This divergence in views on risk may lead to the sub-optimisation of capital allocation, pricing, product development and other tools and processes related to risk management.
Regulatory reforms could push an increasing amount of financial activity towards an unregulated “shadow banking” sector, with unclear consequences for systemic risk.
New capital regulations will reduce incentives for providing low-risk lending. Risk-insensitive rules will incentivise banks to increase exposure to high-risk lending to maintain a reasonable risk-adjusted return. This is mainly caused by the increased capital cost for assets hit by the capital floors (see Section 3), which is not incorporated in current pricing. This may put institutions’ risk management organisations under pressure as the incentives for higher-risk lending increases.

In this report, we begin by comparing the capitalisation of Swedish banks with their European peers. We then describe the most significant of the forthcoming regulations and estimate their implications for the capital requirements of Swedish banks (Sections 3 and 4). Banks have several options for increasing their capital ratios in response to these regulations, and we consider these in Section 5. Finally, we consider the costs that will flow through to borrowers and the implications for the wider economy.