Concepts and indicators like (a) whether a society or a geographical area is or isn’t cash-based and (b) the spread of the systemic banking system, are often core concerns of academics, economists and technocrats. And thereof frequently encountered these to relevant legal material and constitute objectives on the political agenda of institutions. For example, the wording chosen by the European Parliament in its 2005 resolution on development and migration is illustrative, as it concluded for “[c]alls on the Commission, the Member States and national and international financial institutions to implement policies aimed at: – promoting and facilitating the transfer of migrants’ funds, ensuring that they are less costly, swifter and safer, in order to encourage migrants to use formal transfer systems – improving migrants’ access to financial services.”1
Firstly, it is crucial to accept that the western-traditional banking system is neither the only financial network out there, nor always the first choice of its potential users. Secondly, governments and other political factors have excellent reasons to promote the systemic-banking concept. The so-called “too big to fail” agenda is grounded on numerous policies, besides protecting the profitability of the banking market. The above-quoted call-to-action of the European Parliament is something beyond a suggestion to the banks to introduce niche marketing strategies.
Nowadays, credit institutions have access to ultimate CPU power, and they can execute the most advanced signalling equations and other math models.
The essay’s author strongly believes that when we do a critical analysis of capital regulation, we should also consider the social and political context. Over-regulation of financial transactions increases costs and reduces the flexibility of any centralised banking system. The ever-increasing “banking bureaucracy” will exclude more and more users. We face a relationship like the Uroboros symbol; we also have to consider that over-regulation is connected with a risk of making banking inaccessible to a proportion of law-abiding users. The examination should be carried out in such a way as to be able to envision the desirable adjustments to the legislative and, after a comparative analysis, understand the socio-economic conditions in those regions where the financial services are significantly different, like hawala or transaction through the WeChat platform.
Depositors are only one of the two general categories of the potential users of a bank. Strictly speaking, one of the three; if we include investors and investing services. Borrowers play a crucial role too, and again, there are plenty of alternative concepts, even when we have to conclude, concepts like informal (and/or shadow) value transfer systems, which are usually grounded to the concept of microfinance. Maybe the most popular microloan service was the Alipay subsidiary of the Alibaba Group, which these days is facing serious penalties as part of a push to rein in the “unruly growth”.2
In another level of the discussion, we also have to conclude that refugees and migrants’ challenges are still active and unsolved during the current decade. Fintech companies are more successful than ever, while conventional banks are in the midst of loan securitisations and other loan transfers as the tech giants strive to reform the global market and consumer habits. At the same time, bankruptcy, insolvency, and second-chance frameworks have been established already; without being underestimated that borrowers are always free to take their chances by attempting to issue the appropriate interim order.
To futher our discussion, consumer and business creditors are characterised by a cyclical behaviour. In an upturn of the market(s) and/or creditors’ optimistic beliefs, loan services are far more easily accessible, and banks are encouraged to sanction loans and fund individual activities and business developments at lower interest rates, and cheaper fees or other terms. That economic expansion turns in an increase in inflation, and that has a positive effect on the value of the loans’ collaterals which finally drives to a financial accelerator effect.3 During that “blowing stage”, the confidence of the expected profitability is high and further rises the prices of commercial goods. Consequently, the banking system, which is heavily exposed through the collaterals, seems solid and healthy.
Herring and Watcher explain that systematic over-lending in good times can lead banks to a “disaster myopia”.4 In a downturn, there is an oversupply of assets and investments, a so-called “frenzy stage” primarily caused by the preceding speculative boom in the markets. Companies may find themselves unable to generate sufficient income to cover the increased interest rate. Refinancing becomes increasingly difficult to get as lenders grow more cautious and less willing to give loans when the value of products as collateral declines.
During the attempt to present a critical explanation of what secure the healthiness of the bank’s balance sheet, we should go through the contrast of poor regulation of the banking system, which promote the abovementioned “disaster myopia”, and the over-regulation, which dismiss proportion of the population from the access to the bank network.
The maths behind dishonesty borrowers
Many mathematical models describe the loan market and the behaviour during the execution of a credit facility agreement, which may even take account of the complexity of the modern market and the extrinsic regulatory framework that governs the market.5
One of the ways is through simulation of the regulatory framework with a kind of quota, and also assuming that the lender does not know whether the borrower is honest or not. The Stiglitz-Weiss model6 predicts that a unit increase in the borrowing cost (e.g., interest rate) will not lead to more profitability to the lender. That increase in interest rate is not enough to absorb the increase in the risk, which is associated with a further increase in the volume of the credit institution’s exposure. Although some techniques have been developed that directly contribute to lenders’ level of knowledge, the situation of a perfect information symmetry is a utopia. It is, however, possible to signalling7 the type of borrower in question. For example, it has been observed that low-risk borrowers tend to accept higher collateral more easily than a higher interest rate. The high-risk borrowers are willing to shoulder higher borrowing costs just to gain access to the credit market.
According to Martin Alberto8, if we interpret the concept of guarantee as a screening mechanism, then the determination of the desired risk is realised under the terms of the intrinsic equilibrium of the specific negotiation case. In other words, under any equation of supply and demand for credit facilities, and beyond the exogenous forces and the endogenous negotiation between the parties, there are likely to be cases where the bankruptcy of the borrower is either the only rational option, or the more advantageous choice than continuing to repay the loan obligations.
Visualising the Stiglitz and Weiss model, we observe two areas where banks show losses in their lending activities. These regions are (a) for interest rates below r1 and (b) for the interest rates between r* and r2. The astonishing thing is that honest borrowers in the second region have withdrawn their demand for a loan. The ability of credit institutions to de-recognise the non-performing loans from banks’ balance sheets is probably an option that should be expected to be granted, sooner or later, even to small local markets, like Cyprus. So, securitisation is a type of debt financing that will meet both needs, increasing capital and risk absorption.
A relevant milestone of the Cypriot national law is the Securitization Act of 2018, which was followed by the amending of the Purchase and Selling Credit Facilities Act of 2015. In both cases, one of the legislator’s priorities was protection and the enhancement of the borrower’s rights.
Generally, securitisation is a packaging method of financial assets with similar characteristics; after the packaging, we try to sell these to investors as securities. Examples of assets used in securitisations include receivables, such as payments on mortgages, credit cards, assets leases, or car loans. Securitisation allows the Originator entity to refinance by transferring a group of loans that originated or otherwise acquired to another entity. Such kind of investors, and contrary to the Purchase and Selling Credit Facilities Act of 2015, shall be governed by the framework of Securitization Special Purpose Entity (SSPE). Regardless of the exact characteristics of these loans, it is just a “trading transaction” between the originator and the investor.9.
On 3 January 2018 the Ministry of Finance of Cyprus sent a request to the European Central Bank (ECB) for an opinion on a draft securitisation law. The ECB’s competence to deliver such an opinion is based on Articles 127(4) and 282(5) of the Treaty on the TFEU and the Article 2(1) of Council Decision 98/415/EC1, as the issues at stake influence the stability of financial institutions and markets. In the opinion included several recommendations and warnings, despite initial applause of the draft and an outward expression of its assessment that it is intended to relieve banks’ balance sheets of a significant volume of non-performing loans and thereby remove the impediment to business and consumer functioning. In summary, these objections were:
- In relation of the extent of the CBC’s power to supervise such activities. For example, the criterion that the securitisation under consideration should not affect the smooth functioning of the Cypriot securitisation market was considered too vague.
- In relation of the notification to borrowers. The ECB commented that this is not a common practice, and the administrative costs of these notifications can be very high. And, most importantly, these notifications are not followed by any option for borrowers to submit a counter-offer like in the case in Purchase and Selling Credit Facilities Act of 2015. ECB claims, there is nothing to prevent borrowers from applying to resettle the loan, including an early repayment.
- In relation of the debtor’s right to set-off. The ECB believes as an obligation of fully recover the liability arising out of exercise the set-off right, would cause securitisations to be highly inefficient for originators, thereby reducing the use of securitisation as a financing tool.
Basel Committee: Imposing the Good
The Basel Committee for Banking Supervision (BCBS or just Basel Committee) was formed in 1974, with the aim to face the fact that conventional credit concentration in markets, such as real estate, is the major source of credit problems around the world. 15The approach was, and still is, to advise national financial legislators on common capital requirements for internationally active banks. At present, the Basel Committee’s membership includes representatives from the central banks and prudential regulators of more than twenty-eight jurisdictions.
In their race for higher market shares during the 1980s and 1990s, banks rapidly increased their exposures without corresponding increases in capital.16At the same time, many countries experimented with deregulation of the markets. That deregulation promoted international banks to a short form of “jurisdictions shopping” and taking advantage of differences in national treatment of similar assets for capitalisation.17 That exploitation across jurisdictions was producing unhealthy competition and regulatory arbitrage. In short, national regulation did not always require all kinds of exposure reflected honestly at bank’s balance sheet, especially when the exposure was not national. Consequently, the need for minimum levels of capital exposure within the international financial system came up, and the result was Basel I.
The aspiration for Committee was to stabilise the relationship between commercial banks’ equity capital, as expressed by its core (Tier I) and supplementary (Tier II) elements, and their risk-weighted assets. The Basel Committee firstly intention was to define what we shall consider as regulated assets. Tier 1 capital generally represents the highest quality of capital, such as common equity and some types of preferred stock. On the other hand, Tier 2 represents a range of lower quality instruments often dubbed as “supplementary” capital, like subordinated term debt and certain hybrid instruments. BCBS set out that at least half of the capital shall consist as Tier 1 and also that banks should maintain the 8% capital to risk-weighted assets and required that four per-cent capital be held against residential mortgage loans.
That original focus was excessively narrow since the exposure was recognised as an internal element of the banks and utterly tied to the institutions’ balance sheets. So, in 1996 “Basel I” was revised. Basel II consisted of an expansion way to assess credit risks, and BCBS accepted the importance of market exposure. The first variable of Basel II was an equation based on Basel I, and the second variable was the effect of the external ratings of the global market, as these ratings were given by firms like Standard & Poor, HSBC, and Fitch.18
Basel III introduces macro-economic mechanisms such as a global leverage ratio and a universal risk equation to address the systemic financial system as a whole. Of course, the microeconomic level was not overlooked, and all of a bank’s accountant needs were progressively and over time revalued, with the addition that banks will be required to function under the new mechanism of a conservation buffer19 on the top of Tier 1 capital ratios.
There is a dual nature at the Basel III is a firm-specific, risk based framework but as well a system-wide, systemic risk-based framework. The system-wide dimension consists of five elements. Firstly, is a leverage ratio, a simple measure of capital that supplements the risk-based ratio. Secondly, the mitigate procyclicality, including a countercyclical capital buffer and the promotion of expected losses rather than incurred losses.20 After, a macro-economic overlay to address the externalities generated by the loss-absorbing capacity. Fourth is the need to face the risk arising from systemically derivatives markets. And finally, the macroprudential overlay aims to better understand the systemic risk through risk modelling, stress testing and scenario analysis.
The mixing of equity and debt to promote a transaction or an investment is called leverage. Someone buys a € 200.000 house and makes an initial payment of € 20.000, and receives a loan of the rest, with collateral the house itself. The house as capital and asset has been leveraged up to € 200.000 following a € 180.000’s debt. It’s a big part of western culture, and people used to take out loans to buy daily assets, cars, houses, or even to pay for health treatments or tuitions. For big companies, it depends upon many reasons, and their opinion for the desirable capital structure; the mystery of zero-leverage firms nothing vicious hides, besides creative management and personal preferences of board’s executive members. Giant companies may have enviable cash-flows, and restricting themselves to an all-cash strategy is perfectly possible and the tech-wearable Garmin Company is a characteristic example of it.
But let’s consider a € 100.000’s investment of liquidated assets plus a 1:9 leverage, and the market faces a half downturn. The net position is now a negative € 400.000, and the bankruptcy says hello.
Although, banks differentiated from giant companies. Even then a perfectly conservative bank, which offers only depositors services, has liabilities in its balance sheet, the sum of the deposits. A bank with no debts is a bank that offers only loans services, which means that it face the totally exposure and resembles to moneylenders.
Of course, attempts like the Basel Committee for Banking Supervision are genuine efforts to prevent banks from defaulting on their debt and from failing. But this attempt can be holistic.
The Greek term of financial markets is “Χρηματοπιστωτικές Αγορές”, it includes the word “πίστωση” (credit), which is a word by the root of “πίστη” (faith). There is no faith without a projection to the future. The critical differentiation between Freddie Mercury and Jesus Christ, is that (we have the faith that) the latter has overtaken his own death; otherwise, the show should have had go on, and the latter was only a superstar.
Financial markets include people’s projection of the future; that we can become sophisticated educated, that we are able to overtook health issues, and is possible to build our dream house. Strictly regulating the volume of the financial markets, itself including the regulating people’s dreams.
It is true that last decades, we have faced numerous financial crises with incurable effects. It is also true that we have already innovated fancy financial products, like securitisating the loans’ risk or cultivating the political will to guarantee the deposits by hard law. Nowadays, credit institutions have access to ultimate CPU power, and they can execute the most advanced signalling equations and other math models.
Over the previous several decades we met people without access to the systemic bank system at all and we saw people to prefer legal arrangements like WeChat pay services. Our societies face unemployed people who switch to moonlighting labour and there is an immediate call-to-action to handle unregulated currencies.
Soft law regulations, like the legal texts from Basel Committee and their hard law national implementations, try to solve dynamic issues and protect the whole world from dynamic dangers. Basel I was finalised in 1988, Base II in 2004 and Basel III in 2010. In these texts, many important factors, for example the Common Equity Tier 1 ratio, are expressed as hard-written numbers and not as dynamic variables. Due to covid-19, freelancers and SME were forced to handle periods of non-working at all, and under the same cases, they weren’t even eligible for government aid. That proportion of the population may have been willing to pay a huge interest-rate for a few investments to improve their ability to provide remote services. In such cases why should someone be against to the “sinner bank” for trampled same ideal ratios because lend these types of businessmen?
In the last and the current decade, we became witnesses of the launching of numerous radical financial products and investment opportunities. We are talking about more than 1000 cryptocurrencies, peer-to-peer lending or micro platforms, micro-loans markets and exchanges markets dedicated to trading environmental carbon emissions. We are experiencing a new peak of democratisation of the trading opportunities and the majority investment portfolios characterised by extremely dispersion. If some businesses and investors are demanded to buy or invest in products of securitised loans, we should let these markets expand and run their course.
The Basel Committee and other similar efforts must reassess thensekves, considering how people utilise the bank system nowadays. Hoping that Basel V21 willmake every effort to capture the corruption, the arrogance and the unreasonable risk, without trying to shape the postmodern financial markets.
- European Parliament resolution on development and migration, 6 July 2006, Strasbourg (2005/2244(INI)), para 21 ↵
- Agence France-Presse & Reuters, “Alipay: China’s biggest payment app faces new curbs”, Deutsche Welle (13/09/2021), <https://www.dw.com/en/alipay-chinas-biggest-payment-app-faces-new-curbs/a-59165463> accessed 28/10/2021 ↵
- Davis, E. Philip, and Haibin Zhu, “Commercial property prices and bank performance” (The Quarterly Review of Economics and Finance 2009) 49(4), pp.1341-1359. ↵
- Herring, Richard J., and Susan Wachter. “Real Estate Booms and Banking Busts: An International Perspective” (Wharton School Center for Financial Institutions, University of Pennsylvania, 1999). ↵
- Hossain Akm Rezaul, “A Simple Model of Credit Rationing with Information Externalities” (2005). ↵
- Stiglitz, Joseph E., and Weiss Andrew. “Credit rationing in markets with imperfect information” (The American economic review 1981), 71(3), pp.393-410. ↵
- Milde, Hellmuth, and J. G. Riley, “Signaling in Credit Markets” (The Quarterly Journal of Economics, Oxford University Press, 1988), 103(1), pp. 101–29 ↵
- Martin Alberto, “A model of collateral, investment, and adverse selection” (Journal of Economic Theory, 2009), 144(4), pp. 1572-1588. ↵
- In CGAP’s technical manual on securitizations, the contract template of general securitization, they call it as “Contract of Sale and Services” – Consultative Group to Assist the Poor, ‘Securitization: A Technical Guide’ (October 2019), <https://www.cgap.org/research/publication/securitization> accessed 31/10/2021. ↵
- Regulation 2017/2402/EU, recital 11. ↵
- Article 44 of the Securitization Act of 2018. ↵
- Article 15(1) of the Securitization Act of 2018 ↵
- Article 16 of the Securitization Act of 2018. ↵
- Articles 15(2)(c) & 25 of the Securitization Act of 2018. ↵
- Panagopoulos, Y., and Vlamis, P, “Real estate information technology: Bank lending, real estate bubbles, and Basel II” (Journal of Real Estate Literature, 2009), 17(2), pp 296. ↵
- ibid, 297 ↵
- King, Peter, and Heath Tarbert, “Basel III: an overview” (Banking & Financial Services Policy Report, 2011), 30(5), pp 1 ↵
- ibid, 5. ↵
- id. ↵
- ibid, 6. ↵
- Basel IV is already agreed in 2017 and planned to be enforce at 2023. ↵