Negotiations surrounding Brexit will soon dominate headlines, though for the near-term Europe is still focused on post-crisis financial regulations. In both cases, we see a reversal in the decades-long trend of harmonization, with investment implications but without loosening standards.
Three things to watch:
1. Past peak tightening. In the financial sector, the pendulum is swinging back from regulatory tightening, to address potential areas of overlap and unintended consequences. The review is not related to US developments so much as to a recognition that rules were getting onerous, particularly in an environment of weak growth and lending. The reform process since the crisis has been slower than in the US and more complex, with 41 pieces of legislation compared with one. Regulatory tightening probably peaked early last year with the Basel III proposals, and regulators have since worked with market participants to scale back. Standards will still get tougher, as new measures will be implemented in the next few years, but they are less aggressive than originally drafted, and the industry has more certainty.
Investment takeaway: Clarity on regulations is important for banks to switch their focus from building up capital to ramping up lending, which is beneficial for consumers and business. Lending in the US has been more robust and two-way in terms of supply and demand, and we would expect Europe to start catching up, particularly against a backdrop of improved economic growth.
2. De-harmonization. The second issue is increased fragmentation of financial regulation after an attempt to enforce global standards. Since the early 1990s regulators have worked toward global harmonization. Standards for capital requirements were intended to help build trust in foreign banking systems, and promote globalization of banking products and services. That trust broke down after the financial crisis, as officials cared more about the safety of their own banking system. Re-regulation has come about as each jurisdiction has revised its own standards in isolation. And more barriers are being erected on the basis that it is easier to supervise smaller banks with compartmentalized capital and funding.
Investment takeaway: Our fundamental equity team sees dispersion as banks adjust their business. Those that have gone down the path of globalization may struggle, because a large single-jurisdiction bank may fare better than a small one operating in various jurisdictions. Some banks have retrenched on the view that economies of scale are possible only in local jurisdictions. Our investment strategy is focused primarily on banks with simple business models that are big in their own markets, and these banks tend to be retail.
