Where next? The impact of banking regulations in Belgium

Transcription

1 Where next? The impact of banking regulations in Belgium

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3 Contents 1. Executive summary 2 2. The contribution of the banking sector in Belgium 6 3. Quantifying the economic impacts of banking regulations Key findings Policy implications Appendix Appendix Contacts 43

4 Executive summary The Belgian banking sector performs a critical role in financial intermediation, by facilitating the flow of credit between lenders and borrowers, providing maturity and risk transformation, and handling payment systems. Banks also help businesses manage their risks and investments, raise capital, and facilitate efficient flows of domestic and international capital. The banking sector in Belgium generated 14.2 billion of gross value added (GVA) in 2013, which is around 4.3% of Belgian national GVA, and provides employment for around 66,000 people. However, despite this contribution, the 2007 financial crisis clearly illustrated the risks associated with the sector. Regulatory reform remains at the top of the financial sector policy agenda, with the primary objective being to ensure that the costs of excessive risk-taking are borne by banks and investors rather than taxpayers and businesses and to preserve the stability of the financial system. Regulatory reform is not without economic consequences. There will be an adjustment process as firms seek to comply with new regulatory structures, while reforms that require banks to hold more capital could drive up prices and reduce the availability of lending. These reforms may well reduce risk, but there is no guarantee they will be able to insulate the Belgian economy fully from future financial crises. This report examines the economic impact of these regulations both in terms of their costs and shows that they could lead to a reduction in the level of GDP between 0.7% and 1.5%, which is equivalent to billion per annum, relative to an environment where the Belgian economy grows in line with a long-term steady state growth rate of 1.8%. The implication of this assumed growth rate is that no further financial crises will impact on the Belgian economy, once the regulations take effect. This study is an initiative launched by Febelfin, which called upon PwC for the necessary macroeconomic analysis and banking sector expertise. Febelfin was instrumental in facilitating access to key stakeholders within the banking sector in Belgium, and providing other sectorspecific data. This report emphasises the need to carefully weigh the benefits of introducing further regulations on the sector against its costs, taking into account the importance to Belgium of a competitive banking system capable of supporting essential intermediation services for the real economy. 1 2 The impact of banking regulations in Belgium PwC

5 1.1 The policy context During the financial crisis, when markets failed to provide financial stability, governments were compelled to bail-out banks deemed too big to fail, at a cost to the taxpayer. The fiscal costs have been significant. By the end of December 2009, direct support in the form of pledged capital injections and asset purchases by G20 economies amounted to US$2.1 trillion equivalent to 4% of their gross domestic product (GDP) 1. As funding markets dried up and capital positions deteriorated, governments provided capital injections and other asset guarantees to support the financial system. One such example is the state bailout of Dexia once the world s largest municipal lender by the Belgian and French governments. This initially amounted to 6.4 billion, but by the end of 2012, it needed further capital injections of 5.5 billion 2. At the EU level, new regulations have been introduced in the banking sector aimed at reducing the likelihood and costs of future crises. New banking rules and supervisory mechanisms aim to improve bank capitalisation and their resilience to shocks. These are also intended to curb excessive risk-taking and to stem the contagion from risky activities to vital intermediation activities. In the event of bank failures, regulators also need to ensure that the supervisory, crisis management and resolution arrangements for global systemically-important institutions are effective and reflect the interests of the home and host countries. In Belgium, policymakers have also implemented various bank taxes and have proposed capital surcharges on banks trading activities. The regulations that have been introduced in the EU include the Capital Requirements Directive and Regulation (CRD IV), the Recovery and Resolution Directive (RRD), the Single Resolution Mechanism (SRM), structural banking reforms, the Financial Transaction Tax (FTT) and other banking taxes. At the national level, the Belgian parliament has also enacted the new Belgian banking law of 25th April IMF (2010). 2 Reuters (2012). PwC The impact of banking regulations in Belgium 3

6 1.2 The impacts were measured against a baseline scenario, which describes a pre-2013 regulatory environment and where the Belgian economy grows in line with a long-term steady state growth rate of 1.8%. Scenario analysis of the impacts of banking regulations This report is the first attempt to quantify the combined impacts of introducing banking sector regulations in Belgium. There is still some uncertainty over the final form these regulations will take and how they will be implemented. Many banks are still struggling to understand their business implications and how they will respond. In order to gain a sense of the magnitude of the economic impact of banking regulations, we have developed two scenarios that differ in regulatory severity and impact, with Scenario 1 specifying a set of regulations that are less severe than Scenario 2. The two scenarios are based on our review of official documents on policy design. The macroeconomic impacts of the regulations under the two scenarios have been assessed over a 30-year time horizon. The impacts were measured against a baseline scenario, which describes a pre-2013 regulatory environment and where the Belgian economy grows in line with a long-term steady state growth rate of 1.8% 3. Scenario 1 combines the impact of the CRD IV, bank resolution mechanisms such as the RRD and SRM, structural banking reforms and banking taxes, and reflects the current regulatory landscape. Scenario 2 combines the impact of the regulations considered in Scenario 1 but with more severe regulatory requirements, and also includes the FTT and the continuation of the financial stability contribution. We used a bespoke dynamic economic model, called a Computable General Equilibrium (CGE) model, to assess the economic impact of these regulations. The model contains a set of equations that numerically simulates the behaviours and economic interactions of all agents in the economy (firms, households and the government). These models are a standard tool of empirical economic analysis, and are widely recognised and used by international organisations such as the IMF, the OECD and the World Bank, as well as the EC, national governments and central banks. 3 The implication of this assumed growth rate is that no-further financial crises will impact on the Belgian economy, once the regulations take effect. 4 The impact of banking regulations in Belgium PwC

7 1.3 Our findings Our analysis suggests that the impact of introducing the regulations we considered could be significant. The CGE model shows that introducing these regulations could result in a permanent social cost through reduced GDP of between 0.7% (Scenario 1) and 1.5% (Scenario 2), compared with the baseline level of real GDP, which is equivalent to billion per annum. This cost can also be expressed as a present value over 30 years of billion 4. The regulations are also expected to have significant impacts on the banking sector. Banking sector GVA is modelled to be around 5.6% and 13.2% lower in Scenarios 1 and 2 respectively compared with the baseline. The insurance sector and auxiliary financial services sector are also adversely affected. The impact on employment is also significant there are expected to be 25,000 and 81,000 fewer employees across the economy as a whole under Scenarios 1 and 2 respectively, with a disproportionate amount of job losses occurring in the banking sector and in those sectors with deep inter-linkages with the banking sector, such as insurance, auxiliary financial services and real estate services. 1.4 Structure of the report The rest of this report is structured as follows: Section 2 analyses the contribution of the banking sector to the Belgian economy in more detail. Section 3 sets out the economic modelling approach used in our analysis. Section 4 summarises the key results from the model. Section 5 concludes and summarises the policy implications from our analysis. Further detail on the methodology used in our study is provided in the Appendix. 4 The present value is calculated using a real discount rate of 3.5%, consistent with the approach set out in the European Commission s Guide to Cost-Benefit Analysis of investment projects. PwC The impact of banking regulations in Belgium 5

8 The contribution of the banking sector in Belgium 2 6 The impact of banking regulations in Belgium PwC

9 2.1 The role of the banking sector in Belgium s economic performance The banking sector s contribution to the Belgian economy can be described in various ways, including its role as an intermediary facilitating capital flows from one economic agent to another, its contribution to national output and employment, and its contribution to fiscal revenues. These are summarised in Figure 1. Figure 1: Dimensions of banking sector contribution to the Belgian economy Dimension Impacts and benefits GVA and employment Financial intermediation Direct contribution to Belgian GDP and employment. The banking sector requires intermediate inputs from other sectors, and is an important source of demand for non-financial sectors. Downstream purchases by banking sector employees also benefit the wider economy. The banking sector provides a wide range of products and services to households and businesses. These are important to support productivity growth and economic activity in the wider economy. Supporting the global economy The Belgian banking sector supports economic activity in Europe and beyond by exporting financial services abroad. PwC The impact of banking regulations in Belgium 7

10 66,000 employees 14.2bn of gross value added in 2013 The banking sector in Belgium generated 14.2 billion of gross value added (GVA) in 2013, which is around 4.3% of Belgian national GVA. The sector also provides employment for around 66,000 people 5, which is equivalent to approximately 1.4% of total employment in Belgium 6. The sector facilitates the flow of capital around the economy, and provides financial products to households, businesses, investors and the government. A well-functioning banking sector can improve both capital efficiency and productivity in the economy. Table 1: Real GVA of the Belgian banking sector, Banking sector GVA constant 2011 million Banking sector GVA % p.a. growth Banking sector GVA % of total Belgian GVA ,527 (8.7) , , ,361 (0.4) ,094 (2.3) ,040 (9.5) , , ,680 (4.8) , , Source: National Bank of Belgium, PwC analysis 5 European Banking Federation, European Banking Sector Facts and Figures Based on statistics by the National Bank of Belgium (NBB). 7 Data for 2012 and 2013 estimated applying the historical proportion of GVA of the banking sector within the wider Belgian financial services sector, which also consists of the activities related to insurance and pension funds and auxiliary financial services, in addition to banking and financial services. 8 The impact of banking regulations in Belgium PwC

11 2.2 Who uses banking products and services and what does the banking sector buy? The banking sector performs a critical role in financial intermediation, by facilitating the flow of credit between lenders and borrowers, providing maturity and risk transformation, and handling payment systems. Banks also help businesses manage their risks and investments, raise capital, and facilitate efficient flows of domestic and international capital. Supply and Use Tables (SUTs) published by the Belgian Federal Planning Bureau for the year can be used to evaluate the dependence of other sectors on the banking sector. The SUTs show the different products that industries use in their production processes. Based on 2010 data, the non-banking sector purchased around 9.0 billion in banking products and services. Not all the contributions made by the banking sector to the Belgian economy are fully included in this measure. For instance, banks provide financial advice to clients, automated payment facilities and other services for which the charged costs to clients are either disproportionately low or non-existent. Figure 2: Domestic purchases of Belgian banking sector products, 2010 Real estate services Manufacturing Wholesale and retail trade services; repair services of motor Professional, scientific and technical services Construction Public administration and defence services; compulsory social Human health and social work services Administrative and support services Transportation and storage services Services auxiliary to financial services and insurance services Information and communication services Agriculture, forestry and mining ,117 1,285 1,224 2,494 Accommodation and food services Insurance, reinsurance and pension funding services, except Other services Electricity, gas, steam and air conditioning Water supply; sewerage, waste management and remediation Arts, entertainment and recreation services Education services Mining and quarrying millions ,000 1,500 2,000 2,500 Source: NBB 8 This is the most recent year for which the SUT s are published. PwC The impact of banking regulations in Belgium 9

12 The banking sector also purchases a significant amount of inputs from other sectors in order to produce the products it sells. The data is again obtained from the SUTs. Based on this data, supply chain spending by banks amounted to 11.2 billion in This expenditure is predominantly in services provided by other financial services (FS) sector firms 9. Total supply chain expenditure by banks outside the FS sector amounted to 6.5 billion. Figure 3 shows the amount of goods and services purchased by the banking sector from the rest of the Belgian economy. Figure 3: Banking sector purchases of intermediate inputs from other sectors, 2010 Services auxiliary to financial services and insurance services Professional, scientific and technical services Information and communication services Administrative and support services Real estate services Transportation and storage services Accommodation and food services Manufacturing Other services Insurance, reinsurance and pension funding services Electricity, gas, steam and air conditioning Education services Public administration and defence services; compulsory Arts, entertainment and recreation services Water supply; sewerage, waste management and ,591 2,960 4,675 millions 0 1,000 2,000 3,000 4,000 5,000 Source: NBB 9 Besides banks, the financial services sector includes insurance, reinsurance and pension funding activities and services auxiliary to financial services and insurance. 10 The impact of banking regulations in Belgium PwC

13 The Belgian banking sector is dominated by international banks around 50% of total bank assets are held by subsidiaries or branches of foreignowned banks 10. Belgium is a highly open economy, with exports making up 80% of Belgian GDP 11. Belgium directly exports 6 billion of financial, insurance, pensions and related services (but this was only 2% of total Belgian exports), of which 4 billion are exported within the EU Based on European Central Bank consolidated bank data for Belgium for Belgian Foreign Trade Agency. 12 Data for 2010, Source: Federal Planning Bureau. PwC The impact of banking regulations in Belgium 11

14 Quantifying the economic impacts of banking regulations 3 12 The impact of banking regulations in Belgium PwC

15 3.1 The policy context Financial reform remains at the top of the policy agenda, as there is a renewed impetus for policymakers to ensure that the costs of excessive risk-taking are borne by banks and investors and to preserve the stability of the financial system. In Belgium, policymakers have also implemented various bank taxes and have proposed capital surcharges on banks trading activities. New banking rules and supervisory mechanisms aim to improve bank capitalisation and their resilience to shocks. These also aim to curb excessive risk-taking and to stem the contagion from risky activities to vital intermediation activities. In the event of bank failures, regulators also need to ensure that the supervisory, crisis management and resolution arrangements for global systemically-important institutions are effective and reflect the interest of the home and host countries. The scope of regulations considered in our analysis consists of the key domestic and European level regulations which will impact banks in Belgium. Some of these regulations are yet to be finalised, and the magnitude of the estimated impacts could differ if the scope of the regulations changes. Our assessment includes the following regulations: 1. Capital Requirements Directive and Regulation (CRD IV): CRD IV implements the Basel III accord in Europe and aims to strengthen the resilience of the banking sector so that banks are better placed to absorb adverse shocks whilst ensuring their ability to continue financing economic activity and growth. Banks will be required to hold additional and higher quality capital, as well as to meet short- and long-term liquidity requirements. 2. Bank resolution: The Recovery and Resolution Directive (RRD) seeks to ensure that failing banks can be wound down in a predictable and efficient way with minimum cost to taxpayers. The Single Resolution Mechanism (SRM) reinforces the RRD by centralising, at the European Commission (EC) level, the resolution of banks in member states that are participating in the European Union (EU) Single Supervisory Mechanism (SSM). Under the RRD, banks will be required to hold a certain percentage of their liabilities in the form of bail-inable debt. Under the SRM, banks will be required to contribute to a centralised Resolution Fund to cover the administrative costs of facilitating bank resolution. PwC The impact of banking regulations in Belgium 13

16 3. Structural banking reforms: Authorities at the EC and Belgian national level have introduced legislative proposals for bank separation of varying degrees of severity, which are intended to insulate banks core banking activities that are vital to the real economy, such as deposit-taking and loans to households and businesses, away from activities considered to be riskier, such as trading. 4. Financial Transaction Tax (FTT): The EU 2013 proposal for the FTT includes the introduction of a minimum tax of 0.1% and 0.01% on secondary non-derivative and derivative transactions respectively in 11 EU member states including Belgium. The FTT aims to harmonise financial transaction taxation in the EU and to create disincentives to carry out transactions that do not contribute to financial market efficiency. 5. Bank-specific taxes: Banks in Belgium are liable for annuallyrecurring taxes and other contributions that are specific to the banking sector, such as contributions to the Deposit Guarantee Fund (DGF), the Financial Stability Contribution (FSC), the Annual Bank Levy (ABL) and the Loan-to-Deposit Tax (LTD). Our scope includes assessing the direct costs of these regulations to banks and businesses. We also consider the wider economic impact of the associated higher costs of raising capital for businesses, which have knock-on impacts on investment levels, productivity, economic growth and job creation. We recognise that many of these reforms are intended to reduce the magnitude and frequency of possible future financial crises. Our scope of work did not include any assessment of whether they would achieve this, or the benefits that would result if they did. 14 The impact of banking regulations in Belgium PwC

17 3.2 Our overall approach Our overall approach for each of the regulations analysed follows the steps below: 1. We reviewed documents published by the European Commission and other official sources to understand recent policy developments in the sector. We then conducted an extensive review of the academic and institutional literature (e.g. that published by the OECD and the IMF) to collate possible bank responses and the subsequent impacts on banks associated with each regulation. 2. We surveyed several banks for their views on the impact of the regulations on their business and the actions they might take in response to them. The respondents to this confidential survey were drawn from banking groups accounting for 67% of the total consolidated banking assets in Belgium. 3. Based on our literature review and the survey findings we modelled the impact of the banking sector regulations listed above. We considered two scenarios which differ in their regulatory severity and impact, with Scenario 1 specifying a set of regulations that are less severe than Scenario 2. The two scenarios are based on our review of official documents on policy design. The macroeconomic impacts of the regulations under the two scenarios were assessed over a 30-year time horizon. Then impacts were measured against a baseline scenario, which describes a regulatory environment where pre-2013 regulations are maintained. The baseline and the two scenarios are described in Table 2. PwC The impact of banking regulations in Belgium 15

18 Table 2: Description of Scenarios 1 and 2 for each regulation Regulation Requirement Scenario 1 Scenario 2 Baseline CRD IV Minimum capital requirement (Core Equity Tier 1 (CET1) as % of Risk-Weighted Assets (RWAs)) Banks to meet a CET1 ratio requirement of up to 11% for large banks by 2019 Banks to meet a CET1 ratio requirement (including countercyclical buffers) of up to 13% for large banks by 2019 Banks maintain 2009 actual CET1 ratios Short-term liquidity coverage ratio (LCR) High quality liquid assets up to 100% of cash outflows over a 30-day stress period by 2015 High quality liquid assets up to 120% 13 of cash outflows over a 30-day stress period by 2015 Banks maintain 2009 LCR ratios Long-term net stable funding ratio (NSFR) Stable funding of up to 90%, to support operations over a 1-year stressed scenario by 2019 Stable funding of up to 100%, to support operations over a 1-year stressed scenario by 2019 Banks maintain 2009 NSFR ratios Bank resolution (RRD and SRM) Bail-in liabilities (% of total liabilities) 8% by % by 2019 No bail-in liabilities requirement Bank contribution to Resolution Fund 166 million a year (replacing banks Financial Stability Contribution from 2015) 355 million a year (reaching 1% of covered deposits within eight years) No Resolution Fund Structural reform Separation Prohibition of proprietary trading activities from 2017 Separation of wider trading activities (including proprietary trading, market-making etc.) from deposit-taking activities from 2018 No separation FTT FTT No FTT Permanent contribution of 1,131 million per annum from No FTT Bank taxes 15 Deposit Guarantee Fund contribution 2013: 445 million 2014 onwards: 280 million a year 2013: 445 million 2014 onwards: 280 million a year 257 million Financial stability contribution 2013 and 2014 only: onwards: 166 million 16 million a year No Financial Stability Contribution Annual bank levy and 490 million a year 490 million a year 226 million loan-to-deposit tax 17 Source: PwC analysis 13 The higher LCR requirement is to capture the impact of restrictions on banks levels of asset encumbrance, as required by the Belgian banking law. 14 This is the mid-point of FPS Finance Belgium s (2012) estimates of tax revenues, based on the 2011 EU proposal for the FTT. This estimate is still applicable to the updated 2013 proposal by the EC as it is specific to Belgium and there is no significant change to the tax base or rate. We note that these estimates are also dependent on how banks respond to the FTT, which is difficult to predict. 15 The scenarios specified for the Financial Stability Contribution and the annual bank levy and loan-to-deposit tax do not differ as there is little policy uncertainty over the implementation of these taxes. 16 In Scenario 1, the Financial Stability Contribution is expected to be replaced by payments to the Single Resolution Fund from 2015 onwards. 17 Otherwise known as the abonnementstaks or the taxe d abonnement. 16 The impact of banking regulations in Belgium PwC

19 We used a bespoke dynamic economic model, called a Computable General Equilibrium (CGE) model, to assess the economic impact of these regulations. 4. We used a bespoke dynamic economic model, called a Computable General Equilibrium (CGE) model, to assess the economic impact of these regulations. The model contains a set of equations that numerically simulates the behaviours and economic interactions of all agents in the economy (firms, households and the government). These models are a standard tool of empirical economic analysis, and are widely recognised and used by international organisations such as the IMF, the OECD and the World Bank, as well as the EC, national governments and central banks. The EC recently used a similar class of model to analyse the impact of the FTT. 5. From the literature review, we identified a set of shocks that could be used to simulate the introduction of new banking sector regulations in our CGE model. Because of the way in which the impacts are estimated in the literature, these shocks were primarily changes in banks cost of debt, the non-financial sector s cost of debt, and the average effective tax rate of taxes borne by the banking sector. 6. The shocks for all the regulations were then combined into a single set of shocks to generate the combined impact of introducing these regulations together for both scenarios. The bespoke CGE model used in our analysis has been adapted to capture the key features of the Belgian economy and its banking sector. It is a scenario-based model: key economic variables are adjusted or shocked, and then the model adjusts over time to a new equilibrium that takes into account the impact of the shock applied for that scenario. PwC The impact of banking regulations in Belgium 17

20 3.3 Modelling shocks From the literature review, we identified a set of shocks that could be used to simulate the introduction of new banking sector regulations in our dynamic economic model. The model results are primarily driven by shocks to: 1. Banks cost of debt and the nonbanking sector s cost of debt; and 2. Shocks to the taxes borne by the banking sector. The primary reasons for constructing the model shocks in this way relates to: Estimates produced by previous studies: Much of the institutional and academic literature estimates the impact of regulations on banks cost of debt and their lending spreads (the non-fs sector s cost of debt), and the wider economic impacts as a result. These output elasticities provide a basis of comparison for the different studies and the different regulations. The comparison of the different studies allows us to consider a plausible range for our estimates. The Appendix provides further detail on the existing evidence reviewed in our study. Our consideration of the underlying economics and the structure of the CGE model: The way in which each regulation affects the economy is different, but there are also some similarities. Most regulations will affect the banks or non-fs sector s cost of debt. It would be possible in the CGE to model each regulation in a different way (e.g. through lending volumes, corporate equity prices etc.), but if this was done, each would have a different transmission mechanism which would make the relative comparison of each regulatory impact more complicated. The cost of debt is a common point of comparison for each of the regulations. Explicit treatment of taxes: Each scenario considers a particular set of taxes (bank-specific, FTT) etc. The Belgian CGE model has been specifically designed to capture the separate characteristics of each tax. Because these taxes do not always impact directly on the cost of debt, and the revenues from some are held in separate government funds (e.g. the DGF), the transmission mechanism for taxes differs from that of the regulatory impacts. 18 The impact of banking regulations in Belgium PwC

21 3.4 Interpreting model results Figure 4 shows how the results from our analysis are interpreted. For simplicity, we have provided this illustration using the level of GDP as the outcome of interest. The baseline scenario in the CGE model assumes that the Belgian economy grows at the rate of 1.8% per annum with no additional regulations; this is shown as the solid line in Figure 4. The CGE model then computes the new level of GDP under a scenario where the new banking regulations are introduced; this is shown as the dotted line. The difference between the baseline and the scenario gives the GDP impact of the banking regulations, which is expressed as a percentage deviation from the baseline level of GDP. These costs represent the steady state costs of introducing the regulations. These are the GDP impacts we refer to in our findings. Figure 4: Interpreting model results Level of GDP ( millions) Area X is the cost of introducing the regulation if no expected crises Baseline (solid line) The baseline assumes that the economy grows at the long-term growth rate of 1.8% without any additional regulations. Area X Scenario (dotted line) Takes into account the impact of introducing additional regulations without experiencing additional crises. The economy experiences a regulatory shock PwC The impact of banking regulations in Belgium 19

22 3.5 In the CGE model the rise in the cost of debt in the banking and non-banking sector triggers a reduction in the level of economic output and both sectors contract in size. How does a change in cost of debt affect the model? In the CGE model, a change in the banks cost of debt raises banks overall cost of capital. In practice, it is difficult to predict how banks behaviour will adapt to the introduction of new regulations and banks are likely to respond using a combination of repricing products and services or cost reduction (withdraw from less profitable activities and drive efficiencies across the business). In the CGE model the rise in the cost of debt in the banking and non-banking sector triggers a reduction in the level of economic output and both sectors contract in size. This reduction in output is associated with a range of effects described in Table 7 below. Table 3: Wider economic impacts from an increase in the financial and non-financial sectors cost of debt Investment effect Capital labour substitution Employment effect: income Employment effect: substitution Human capital effect Multiplier effect (upstream) In the long-term, the cost of debt increase has a permanent impact on the cost of investment. Planned capital expenditure becomes more expensive, and as a result, is put off or delayed, especially for marginal projects. This effect is large relative to many of the other effects and is one of the primary drivers of the negative GDP impact. Reduced productivity and profitability for Belgian banks reduce returns to labour and capital. Lower wages mean that businesses find it harder to attract employees if they want to grow. However, capital has become more costly, so they may seek to use less capital inputs and more labour inputs in their production processes. This effect is marginal; it is unlikely that businesses will unwind their current capital positions, but going forwards, their growth would be more focussed on expanding their workforce. The strength of this effect will depend on the availability of potential workers and their willingness to supply labour to the market. Workers in the model have a reservation wage based on the opportunity cost of reduced leisure. The capital-labour substitution effect suggests that future growth in Belgium might be more labour intensive, but overall employment levels and wages fall. Under the income effect, workers might supply more hours to the labour market in an attempt to offset any reduction in wages. A reduction in wages reduces the opportunity cost of an hour of leisure time. In the model, more well paid workers reduce their labour supply at the margin as the value of working an extra hour has fallen. If workers reduce their hours or become unemployed, this has the effect of reducing their overall stock of human capital. In turn this can lead to a reduction in productivity. Each time a worker moves between a sector of the economy in the CGE model, they must retrain (sector specific skills only have limited use outside of that sector), and this retraining period also leads to a dip in productivity. The decline in output in the banking sector and in the wider economy reduces intermediate demand for inputs from suppliers. This means that the negative effects are multiplied. There will be knock-on impacts on aggregate demand as workers spend less on goods and services in the Belgian economy. 20 The impact of banking regulations in Belgium PwC

23 Multiplier effect (downstream) Price effect Trade effect Crowding-in effect Resource movement effect Businesses and households who buy services from the banking sector experience price rises as the banking sector passes on the costs of the regulations. This has the effect of reducing output and household consumption in the wider economy. As real GDP and aggregate demand decline, there is downward pressure on prices, dampening the effects of inflation. On the other hand, the increase in the cost of capital for businesses which is passed on to consumers results in upward pressure on prices. The impact on overall price levels is therefore ambiguous. The effect on Belgian trade is negative. The reduction in the economy s productive capacity means that Belgian exports decline, and domestic production is unable to fulfil domestic demand. This means that imports increase. An increase in taxes levied on the banking sector reduces investment in the sector, which has negative downstream effects on the sector s suppliers. Resources are reallocated from the banking sector to other parts of the economy as returns to capital in the banking sector decline. Other sectors may expand, but these sectors are also negatively impacted by the shrinkage in the banking sector. The reduction in overall output as a result makes it harder for Belgium to close its output gap 18. A parameter in the CGE model that is central to determining the rate of return to savers and the cost of borrowing is the capital risk premium. In the CGE model each sector of the economy has its own separate risk premium this premium is determined net of capital depreciation in each sector and is part of the investment function in the CGE model. The introduction of the new regulations only leads to a small reduction in the risk premium across all sectors. There are three key reasons for this: 1. The various regulations increase the amount of capital on banks balance sheets which puts downward pressure on risk premia. However, banks may take on more risk in order to generate funds to pay depositors, or to generate returns for investors that are consistent with returns offered prior to the introduction of the regulations or that are internationally competitive. Other international markets will be affected by banking regulations (some more severely than others) and this is accounted for by halving the elasticity that would govern international capital flows in and out of the Belgian banking sector. These two effects largely net each other out, and the decline in the banking sector s risk premia in both Scenario 1 and Scenario 2 is less than 100 bps. 2. Some activities (certain types of trading activity and capital issuance to businesses where there is less public/analyst information) that is normally undertaken by the banking sector may move to the shadow banking sector, which is less well regulated and has a higher degree of risk associated with it. 3. If non-fs sector businesses choose not to use debt finance to fund their economic expansion then alternative sources of finance can incur higher levels of risk e.g. issuing equity could change the ownership structure of a firm. In effect, the model suggests that while the overall level of risk does not change substantially, the underlying type of risk borne by the Belgian economy is quite different to what has been previously observed. 18 Belgium s 2013 output gap is estimated to be 2.3% of potential GDP. See the Belgium National Reform Programme pdf/csr2014/nrp2014_belgium_en.pdf. The output gap is the difference between actual output of an economy and its potential output. An economy s potential output is the maximum amount of goods and services an economy can produce if it is running at full capacity. Belgium s output gap is currently negative, which means that actual output is less than the economy could produce at maximum efficiency. A further reduction in overall output will widen the output gap, making it harder for this gap to be closed. PwC The impact of banking regulations in Belgium 21

24 3.6 How does a change in banking sector taxes affect the model? Next we describe the economic transmission mechanism associated with the tax-based measures: the Deposit Guarantee Fund contribution (DGF) the Resolution Fund (RF), the Financial Stability Contribution (FSC), the Annual Bank Levy (ABL), the Loan-to-Deposit (LTD) and the Financial Transaction Tax (FTT). The DGF contribution and the RF are not typical taxes, in that they represent contributions to different funds that are earmarked as insurance funds, which would only be deployed for a specific use under certain circumstances, but for the purposes of our analysis they can be treated in the same way as taxes. The legal or initial incidence of each of the taxes considered in our modelling will be on the banking sector. However, banks could seek to pass on a proportion of the tax to consumers of its services. The magnitude of this impact depends on a number of factors: The initial incidence of these taxes is on banking sector capital. Academic studies 19 suggest that capital taxes are among the most economically distortive. These studies suggest that capital taxes reduce the profits of firms, inhibiting both domestic and foreign direct investment and reducing the rate of capital accumulation in the economy. Capital taxes also hinder productivity through a number of channels, including distorting relative factor prices, causing high compliance costs and hindering technology transfers and knowledge spillovers. Capital taxes also have a compounding effect: one unit of capital that is taxed today cannot be utilised for future growth tomorrow. The CGE model suggests that this compounding effect is particularly strong. When coupled with the reduction in productivity, these form the primary drivers of the economic distortions introduced by these types of taxes. Whether the taxes are passed on or not, the CGE model suggests its incidence remains on either banking sector or non-banking sector capital for 2-3 years. After approximately 5 years, about half the tax passes on to wages in both the banking and non-banking sector. If the taxes are absorbed by businesses then they will become taxes on business inputs, which is one of the more distortive ways of raising tax revenues. A study by Diamond and Mirrlees (1971) shows that taxes on business inputs are relatively more distortive, as both the production and consumption decisions are affected. As the price of one input increases, banks may adjust their behaviour by using less of the taxed input, switching to alternatives. The productive potential of these inputs is therefore not maximised and reallocated to less productive firms, which results in overall lower levels of output. If taxes are passed on to the consumers of banking sector products then the demand for these products will decline. This could lead to banks and firms adjusting their behaviour, e.g. by ceasing to trade in instruments that are subject to the tax, reducing overall turnover volumes and liquidity in financial markets. In the case of the FTT, this type of behavioural change is directly incentivised by the tax. These price increases cascade through the supply chain and are passed on from one firm to another, and ultimately affect final prices for consumers. This is the same cascading effect described in the subsection above on cost of debt impacts. Each tax will have its own initial degree of pass through. However, after about 5 years the CGE model suggests that approximately 90% of the tax increase will be passed on in the form of higher prices which leads to a reduction in demand and the overall level of Belgian GDP. The reduction in GDP can also be 19 For example OECD (2010), the Mirrlees Review (2011), Gordon and Lee (2004), Kneller, Bleaney and Gemmell (1999) and Arnold et al. (2011). 22 The impact of banking regulations in Belgium PwC

25 explained through an established economic concept called deadweight loss, or a loss of consumer and producer welfare that results from the tax causing a wedge between supply and demand. The way in which the taxes are utilised also has an impact on the economy. In the most basic terms, 1 of tax could be construed as removing 1 of economic activity from the economy. But this approach does not consider the benefits associated with the utilisation or spending of government revenues. As highlighted above, the ABL, the LTD and the FTT are recirculated in the economy as the government increases spending or uses the proceeds to pay down its debts, which has the effect of partially offsetting the initial negative impacts of the tax. Other taxes, such as the FSC, and contributions to the RF and DGF are channelled to a central insurance fund which is not subsequently transferred back into the economy in the form of government spending. However, this contributes to a lower risk premium due to the lowered systemic risks of default, which in turn reduces the cost of debt for banks and non-banking firms. Both of these effects are captured in our CGE modelling and both reduce the overall deadweight loss of the different taxes modelled. PwC The impact of banking regulations in Belgium 23

26 Key findings 4 24 The impact of banking regulations in Belgium PwC

27 Introducing these regulations could result in a permanent social cost through reduced GDP of between 0.7% and 1.5%. Our analysis suggests that the impact of introducing the regulations we have considered could be significant. The CGE model shows that introducing these regulations could result in a permanent social cost through reduced GDP of between 0.7% (Scenario 1) and 1.5% (Scenario 2), compared with the baseline level of real GDP, a difference which is equivalent to billion per annum. This cost can also be expressed as a present value over 30 years of billion 20. Table 4 summarises the impact of each of the regulations, expressed in terms of the average percentage deviation from baseline GDP. Table 4: Macroeconomic impacts of regulations under Scenarios 1 and 2, 30-year averages Regulation Requirement Scenario 1 % deviation from baseline level of real GDP Scenario 2 % deviation from baseline level of real GDP Capital Requirements Directive and Regulation (CRD IV) Bank resolution (RRD and SRM) Minimum capital requirement (CET1 as % of RWAs) Short-term liquidity coverage ratio (LCR) Long-term net stable funding ratio (NSFR) Bail-in liabilities (% of total liabilities) Bank contribution to Resolution Fund (0.45) (0.72) (0.17) (0.28) N/A (0.09) (0.05) (0.08) (0.01) (0.02) Structural reform Separation N/A (0.00) FTT FTT N/A (0.17) Bank taxes Deposit Guarantee Fund contribution (0.01) (0.01) Financial stability contribution (0.00) (0.04) Annual bank levy and loan-todeposit tax Combined effects of regulations (% deviation from baseline level of real GDP) (0.05) (0.03) (0.74) (1.51) Source: PwC analysis 20 The present value is calculated using a real discount rate of 3.5%, consistent with the approach set out in the European Commission s Guide to Cost-Benefit Analysis of investment projects. PwC The impact of banking regulations in Belgium 25

28 The CGE model analyses the wider economy effects, by taking into account the ripple effect of the introduction of regulation. For example, in the CGE model, the increase in banks cost of capital or tax burden results in increasing costs of capital for other businesses and households as banks pass on these costs in the form of higher lending rates and prices for their services. This results in an increase in the cost of consumption and investment in the model, thereby reducing consumption and planned capital expenditure. The model allows for some substitution from capital to labour inputs as their relative prices change. A resource movement effect would also result within the model, meaning that resources are reallocated from the banking sector to other parts of the economy as expected returns to capital in the banking sector decline. The decline in output in the banking sector reduces intermediate demand for inputs from their suppliers, which results in negative output effects for banks suppliers; and banks suppliers in turn, demand less inputs from their suppliers and so on, resulting in a compounding overall negative impact on output. The impact of the regulations on individual expenditure components of GDP are set out in Table 5. There is a significant negative impact on consumption, investment and net exports under both scenarios. Table 5: Impacts of regulations under Scenarios 1 and 2 on expenditure components of GDP, 30-year averages Expenditure component Scenario 1 % deviation from baseline level Scenario 2 % deviation from baseline level Consumption (0.66) (1.25) Investment (0.93) (1.52) Exports (0.18) (0.51) Imports Total GDP (0.74) (1.51) Source: PwC analysis 26 The impact of banking regulations in Belgium PwC

29 In value terms, the impact on consumption is largest, as the effects of Scenarios 1 and 2 translate into lower wages and employment, which in turn adversely affect household spending. Investment is lower by around 1.0% in Scenario 1 in 2030 relative to the baseline, which is estimated to be around 760 million (the equivalent figure for Scenario 2 is 1,150m). This is because the cost of borrowing rises for investors. However, the decline in investment in value terms is smaller than the decline in consumption; this is because more capital-intensive sectors, e.g. construction, are less affected by the shocks because they have alternative capital sources and are therefore able to sustain overall investment levels. Figure 4 and Figure 5 show the impact on the expenditure components of GDP over time for Scenarios 1 and 2. The combined impact of the regulations increases gradually and peaks in 2018 as most of the CRD IV regulations are met. Net exports fall sharply as exports decrease by 0.2% and imports increase by 0.1% relative to the baseline in Scenario 1. For Scenario 2, the effect on trade is more pronounced: exports fall sharply by 0.5% and imports increase by 0.3% relative to the baseline. Figure 5: Impacts of regulations under Scenario 1 on expenditure components of GDP 0.0% (0.1)% (0.2)% (0.3)% (0.4)% (0.5)% (0.6)% (0.7)% (0.8)% (0.9)% (1.0)% 2013 Source: PwC % deviation from baseline GDP Net exports Investment Consumption Figure 6: Impacts of regulations under Scenario 2 on expenditure components of GDP 0.0% (0.2)% (0.4)% (0.6)% (0.8)% (1.0)% (1.2)% (1.4)% (1.6)% (1.8)% % deviation from baseline GDP Source: PwC Net exports Investment Consumption PwC The impact of banking regulations in Belgium 27

30 The regulations are also expected to have significant impacts on the banking sector. Banking sector GVA is modelled to be around 5.6% and 13.2% lower in Scenarios 1 and 2 respectively compared with the baseline. Because of the strong linkages between the banking sector and other financial service sectors such as insurance and pension funding, and auxiliary financial services, these sectors experience substantial GVA declines as well. Real estate and professional services sectors are also significantly affected from the knock-on impacts of the regulations. The macroeconomic impacts by industry sector are shown in Table 6. Table 6: Impacts of regulations under Scenarios 1 and 2 on industry sector GVA, 30-year averages 21 Industry sector Scenario 1 % deviation from baseline level Scenario 2 % deviation from baseline level Agriculture, forestry and fishing; mining and quarrying Manufacturing (0.3) (0.6) Other services (0.2) (0.6) Electricity, gas, water supply and sewerage (4.3) (10.7) Construction Wholesale and retail trade (0.4) (0.8) Transportation and storage (1.0) (2.2) Accommodation and food services (1.3) (4.4) Telecommunications, media and technology (2.1) (4.0) Banking and financial services (5.6) (13.2) Insurance, reinsurance and pension funding (2.3) (4.5) Activities auxiliary to financial services and insurance activities (15.7) (16.8) Real estate services (1.3) (3.4) Professional, scientific, technical and support services (1.5) (3.0) Public administration and defence, education and health services (0.0) (0.0) Total (0.9) (1.8) Source: PwC analysis Scenario 1 5.6% Banking sector GVA Scenario % Banking sector GVA 21 The total impacts reported in this table differ from those in Table 4 because these refer to impacts on GVA, whereas Table 4 refers to impacts on GDP. 28 The impact of banking regulations in Belgium PwC