What difference 20 years make


Due to unforeseen events I’m not in a position to be with you celebrating the 20th anniversary of the Annual Financial Institutions Conference. But I have agreed with Daniel to write a few words on the difference that 20 years make. This way I remind you of two basic principles of the financial markets you work with. First, the presence of uncertainty: ex ante my expectation was to join you for this dinner, but ex post that has not been the case. And second, that there is no free lunch: in this case, no free dinner. The price, on this occasion, will be my dinner speech (my remote dinner speech in fact!).

The first obvious difference that 20 years make is that in 1999 I was 20 years younger and, believe me, that is the most relevant difference. But centring my speech on this idea would not only be totally inadequate, but also a very sad exercise for me and a tedious one for you.

Instead, I will structure my comments around three blocks. First, I will briefly review the evolution of the economy. Second, I will summarize where we were and where we are in the area of financial sector regulation. And third, I will briefly discuss what has happened with the banking sector. Obviously, I will do this, mostly, from a Spanish point of view.

 The Economy

20 years ago, the euro was taking its first steps. It was a moment of pride for all of Europe. In my case, having worked in the European Monetary Institute, I recall the words of our then President, Alexander Lamfalussy, back in 1994, saying that the euro had barely a chance of 50-50 to become a reality. It was not easy; its success should not be taken lightly. 20 years later, the euro has survived the greatest financial and economic crisis since World War Two. In retrospect, we knew the true test of the euro would come with the first crisis, but no one expected such a huge crisis. The crisis meant Spain lost 10% of GDP, putting unemployment at a staggering 27% and wiping out most of the banks. Not only the euro survived the crisis, but the institution behind it, the ECB, has been by far the most effective institution in fighting it. And for Spain it was far better to deal with the crisis within the euro´s institutional framework.

For those of you with an Anglo Saxon background this may come as a surprise: I have had discussions over the last decade denying that Spain would have fared better outside the euro. Being old enough to have lived the last massive devaluation that Spain saw, I do prefer not to be faced with the impact of devaluations on inflation (a terrible tool of income redistribution) and on the social and institutional setup of the country.

Of course, this is not to say that everything went well. The permanent reduction of interest rates brought about by the euro created in Spain a massive real estate boom, followed by a terrifying bust. Other policies, among them fiscal, structural reforms and financial regulation, should have been more proactive in dealing with these initial distortions.

And despite the impact on the social fabric that we have today, the Spanish economy has been able to recover with an export driven economy that has been gaining market share both in global markets and in the Eurozone itself. In fact, we are still growing above our peers in the Eurozone. To sum up, the euro is still worth it from a pure economical point of view.

Regarding the Eurozone itself, we can see greater and greater synchronisation of growth and business cycles within the Eurozone. If the interest rates at the start of the euro were too low for some countries (Spain, obviously) and too high for some other countries, the situation now is totally different.

And the next business cycle that is approaching will be the litmus test on whether the Eurozone is better prepared to deal with a slowdown of growth. My sole fear is not synchronisation of growth, but the potential repetition of the 2012 Eurozone crisis, where domestic agents in southern Europe faced a huge increase in interest rates, in financing costs.

Regulation of banks

Twenty years ago, the Basel Committee was starting the discussion around Basel II. We can say that regulators fell in the scientific illusion of the power of the field of Finance, the quantitative models for financial products pricing and the risk management capabilities of big banks. And, accordingly, they were prepared to let the banks use their internal models for computing PDs, EADs and LGDs. To sum up, they had a blind faith in the technical competence of banks, in particular of big banks.

Banks were ambitious enough not to be totally happy about this. Their aspiration was to go for full portfolio models, allowing for the recognition of diversification of risks across the whole balance sheet of the banks: that was the meaning of Basel III back in those days!

Regarding Conduct of Business rules, they were relatively simple, with plain vanilla rules on the need to avoid conflicts of interest, the fiduciary duty towards the clients and the fight against insider trading.

Twenty years later, we do have a Basel III (even some argue we also have a Basel IV), but of a total different nature that the one foreseen back on those days. This Basel III is by far much more intrusive on each and every aspect of the rules, reflecting a total loss of faith by supervisors on the competence of the financial industry. In fact, it is even worse: they have also lost faith on the character of banks, on their capacity to deal with simple principles such as avoiding conflicts of interest or respecting the fiduciary duty towards the clients. This has been a devastating loss for the banks. And I am afraid that the intrusiveness of regulators, supervisors and the judiciary has not yet reached its peak: I wouldn´t rule out that we end up seeing even price controls being extended to all aspects of banks´ activities.

This explains why we have not just higher capital requirements (higher in volume and quality) but also liquidity requirements, resolution rules that include staggering requirements in terms of resolution capital (MREL), Stress tests, ICAAPs, ILAAPs, governance rules, etc.

But in the area of business rules things are neither better: we have MIFID II and PRIIPs, immensely complex and intrusive conduct of business rules that offer no safe harbour to the industry.

And some of the good ideas of the new regulatory paradigm, such as the concept of capital and liquidity buffers, may never be used. Can you imagine the LCR of a bank going below 100% in stress times? No, the interaction of the rules and markets ensure that banks, rather than letting the liquidity buffer go down, will compete with each other in showing muscle by having LCRs far higher than 100% in stress situations.

But for me the most worrying aspects of regulation after these 20 years are two. First, the complexity of the new rules is immense. The Basel III consolidated text just released a few weeks ago by the Basel Committee has 1868 pages; MIFID II has 5000 pages of text, and the combination of the EU Resolution rules (Regulation and Directives) is longer than the Bible. Why this complexity matters? Because it is almost mission impossible to understand how the interactions of all these rules works. It is a black box, and we only see how it works when looking at the results: the disappearance of small boutiques research and of small company equities research as a result of MIFID II. The problem is that we may not be aware of the results until it is too late: for instance, in a crisis situation. Usually, the risk of complex regulation is the capture of the regulators by the firms. But beyond a point, the risk is total blindness of both regulators and regulated firms, in particular in the medium term outlook for business risks.

The second aspect of preoccupation is the architecture of regulation: we regulate by type of financial institutions, and not by type of activity. And the problem of this kind of regulation is that it is very prone to arbitrage. In fact, we saw this back in 2007: AIG, the monoliners, the SIVs, Lehman Brothers and Bearn Stern were neither banks nor subject to bank regulations: they were insurance companies, broker dealers, SPVs. Now, in this world of technical revolution that is blurring the frontier between financial firms and technological firms, the new regulatory paradigm will be very prone to capital arbitrage, to the appearance of risks within the unregulated shadow banking sector (including in this fintechs and bigtechs).

Let me end up this part by returning to the subject of the lack of faith in the competence and character of banks. If we want to survive the next century, we need to restore the standing of banks with regulators, politicians, the judiciary and the society as a whole. Otherwise, we can expect regulation going in the wrong direction of becoming even more stringent, inflexible, complex and overwhelming.

The Banks

Back in 1999, banks were fully embarked on the Originate to Distribute model (O to D), acting as intermediaries feeding risk transformation across the world. The interlinks in this O to D model were abundant: the interbank markets were showing a febrile activity, thus linking risks across banks; the international banks were using their structure to feed with capital and liquidity fast growing geographies and business areas; and the presence of banks in risk markets was also plentiful, with SIVs, CDOs, CDOs squared, etc. The leverage of the industry was, back then, brutal: banks would operate with as little high quality capital as 1% of assets (or 2% of RWAs). Think about it: we were so sure about banks´ technical capacity that an impact of more than 1% in the value of a bank balance sheet was out of the question. This faith looks scary from today´s vantage point.

Supervisors were happy with it, and their preoccupations were directed to the Hedge Fund world: in fact, LTCM (Long Term Capital management), a Hedge Fund full on Nobel Prize winners, had to be intervened and wound down in 1998. That was the big fear then: a Hedge Fund crisis!

Twenty years later, we cannot say that the O to D model has been abandoned, but we can barely recognise it. The interbank market is gone, the cross subsidies within business areas and countries of big complex international banks have been severely curtailed; and the risk transformation continues but in a far more limited way. And a potential Hedge Fund crisis continues to be the red herring of global financial supervision.

Banks are struggling dealing with:

  • A low interest rate environment that crushes the value of a bank core activity, maturity transformation;
  • Very low balance sheet growth as households and companies continue to deleverage post crisis;
  • Higher capital requirements that have a direct impact on ROEs (the maths are simple: a tripling of capital requirements means three times higher RWAs and ROEs 1/3 of what they were beforehand);
  • Resolution rules and capital, MREL and resolution plans;
  • Higher liquidity buffers (LCRs) and limits to maturity transformation (NSFR);
  • Increased competition fostered by authorities through Open Banking and PSD2;
  • And last but not least the fourth industrial revolution and the emergence of fintechs and bigtechs.

I could add the challenges of sustainable finance to the list, but since we still have a couple of years before it hits us hard (it is already here, but by far not yet with the strength I sense going forward), I prefer to leave it a bit aside.

Looking at all these challenges, it seems a miracle that banks are still alive and kicking. In fact, if you tell me 20 years ago that banks would be capable of dealing with all this, I would have not believed it. In some sense, banks have been performing better than we could have expected.

Let me briefly turn to Spain, because in the banking field Spain was different, as the old advert said, in both positive and negative ways. The first difference is the banking model. The good news is that we did not embark in the O to D model. The bad news is that we had a traditional banking crisis combined later on with the Eurozone periphery crisis. By traditional crisis I mean a poor credit screening done by banks rapidly expanding their balance sheet. And the Eurozone crisis meant a sudden stop of financing flows, á la emerging markets, in the core of Europe.

In the middle of this crisis, the model of our international banks showed its resilience. They were commercial banks, with substantial local market shares, financed locally with deposits and without cross subsidies from the parent either in terms of capital or liquidity. This business model, that was designed to protect Spain from the volatility of Latin America, ended up protecting Latin America from the turbulences of the Eurozone!

But there were also darker areas. 40% of the Spanish banks´ balance sheet changed hands during the crisis, with institutions being either absorbed via mergers or through supervisory intervention (and subsequent allocation through open tenders). From 45 banks of a certain, relevant size, we have gone down to 13, up to now. And the savings bank sector disappeared as such either through individual crisis or through the transformation into share-based private commercial banks. The lessons here were twofold: first, that undefined property rights end up creating suboptimal governance structures that can lead to poor risk management; second, that banks must always have the capacity to increase capital through share issuance during crisis.


As I told you, there is no free lunch, or free dinner. By now I think you have paid a hefty prize, and I will stop here. As the false Chinese curse says, I have been privileged enough to have lived in the last 20 years in interesting times. I am more than willing to forego that privilege and live through less interesting times. But I am afraid that the challenges ahead I have mentioned guarantee that we will still be living in the curse until the end of our professional careers, hopefully not 20 years from now when I will be 75 (but the challenges of an ageing society, may well drive the sanctioned retirement to 75 by the year 2039!).

José María Roldán, presidente de la Asociación Española de Banca