Guest post Semyon Malamud, EPFL: The impact of regulation on the future of investment banking
May 13, 2015

Guest post Semyon Malamud, EPFL: The impact of regulation on the future of investment banking

Due to the regulation costs, the financing by banks becomes much more expensive. The investment banking however, presents many opportunities to the Swiss banks, writes Semyon Malamud of the EPFL.

Investment banking is experiencing an unprecedented regulatory pressure. New regulations make it often too costly for investment banks to keep loans and illiquid asset inventories on their balance sheets. Two major trends arose as consequences of the new regulatory environment: Disintermediation of financing and a changing model of market making.

Traditional bank financing on the retreat

While, traditionally, European banks have been the primary source of financing for non-financial companies, banks are now quickly moving towards the US model in which about 80% of financing is done through capital markets. ECB data shows that between 2009 and 2013 the volume of bank credit decreased in terms of European GDP by 7.4%, while at the same time loan volumes rose by 2.4%.

Shadow banks and securitization as a consequence of regulation

The reason for these developments is clear. With the new capital and liquidity requirements, it is simply too expensive for banks to keep loans on their balance sheets. As I show in my latest paper, disintermediation develops over two key channels: Direct lending by institutional investors (such as, e.g., pension an mutual funds and insurance companies, or “special-purpose” institutions such as private debt funds), commonly known as “shadow banking,” and securitization, whereby institutional investors holds the loans “indirectly,” as parts of the securitized products.

One of the fastest-growing market is that for leveraged loans to companies with a high credit risk. In 2013, leveraged loan issuance in Europe reached EUR 70.8 billion while European high-yield bond issuance came to EUR 96.5 billion Despite these dynamics, European securitization markets are still having a hard time catching up with their US counterparts.

An opportunity for Switzerland

Swiss banks can exploit the disintermediation trend in two ways: by creating new platforms and brands for “Swiss quality” securitized products; and by establishing strategic alliances with shadow banking institutions (e.g., pension funds) or even by creating their own shadow banking spin-offs such as, e.g., lending and intermediation platforms.

Less market making activities

Market making activities of investment banks have also been scaled down due to the regulatory tightening since the financial crisis. The effects for the fixed income markets are particularly large. The new market risk framework, stricter capital ratio requirements, counterparty credit risk charges, and the shift away from over-the-counter to centralized trading have lead to a drop in return on equity of 50-80% for many fixed income instruments.

As a result, investment banks are largely moving to an agency model: they do not hold any inventory and but now simply charge fees for matching buyers and sellers. This has lead to a significant drop in liquidity in many fixed income markets. This calls for designing new mechanisms for trading fixed income. (new trading platforms, etc), andNew platforms such as the UBS Price Improvement Network in Fixed Income (UBS PIN-FI) show that this represents an opportunity for  Swiss banksSwiss banks could exploit this opportunity and create new platforms such as the UBS Price Improvement Network in Fixed Income (UBS PIN-FI).

Semyon Malamud is a Swiss Finance Institute Assistant Professor at École polytechnique fédérale de Lausanne (EPFL) and a Research Fellow at the Center for Economic Policy Research (CEPR)