In 2014, when the ECB introduced the Single Supervisory Mechanism for eurozone banks, Danièle Nouy, chair of the ECB Supervisory Board, had promised that the new supervisory regime for the Euro Area banking sector would be “intrusive, tough but fair”. Is it time to apply this approach to other areas of the financial services sector?
In 2019, I wrote an article in the Business section of Times of Malta, titled ‘The Search for Yield’, highlighting my concern that small investors were being exposed to significant risk in the local debt market.
I wrote: “Many corporate borrowers are increasingly bypassing banks for their financial requirements.
“They go directly to the bond market to obtain the necessary funds for their projects. All kinds of local bond issues are almost invariably oversubscribed. This phenomenon is viewed by those who have financial myopia as a sign of success. The more plausible argument is that many investors who have little understanding of how to price risk are sleepwalking into a potential disaster that could see their wealth destroyed.”
Some practitioners believe that the market is best left to regulate itself: there is no need for sinking funds, no need for credit ratings, and we should rely more on stockbrokers’ advice and arcane credit analysis.
Some local financial intermediaries considered introducing international credit risk grading IT applications to rate local bond and equity issues. After a dry run of the system, they realised that most issues were being classified as sub-investment grade because they failed to satisfy the key performance indicators considered essential for robust credit risk management.
Is this the reason the credit rating of local debt is still elusive? So today, small investors have no practical way to gauge the risk they will undergo when buying private debt in the local market. A grading of private debt risk is essential. Eurozone sovereign debt already benefits from such grading.
Low interest rates and rising inflation persist. While interest rates are not as low as they were a decade ago, central banks continue to use monetary policy to stimulate economic growth, especially in the eurozone, rather than pressuring European governments to undertake structural reforms.
Today, systemically important banks have to follow strict rules in the areas of governance, lending and capital requirements. Most banks started to de-risk. In a nutshell, risks shifted from the strictly regulated banking sector to the more regulation-lite capital market.
We need business-friendly capital markets that are, however, equally committed to embracing the duty of care that regulators, stockbrokers and the business community have to small investors
To compensate, most banks focused on ‘non-interest income’, especially that linked to wealth management. Reforms in consumer protection often took the box-ticking approach. Financial intermediaries continue to engage corporate lawyers to draft complex legal documents, which are typically designed to protect their interests when some debt issuers fail. Courts only enforce the laws. Ensuring justice is quite a different matter.
It is time to state the obvious. Of course, no investment is risk-free; however, it is equally valid to note that well-regulated international markets ensure proper pricing of risk for different investment products with varying risk profiles. It is also worth repeating that the failure of some bond issuers is a reality inherent in both the debt and equity markets. The principle of caveat emptor, let the buyer beware, is hardly a discovery.
The business community has every right to urge the government to promote economic growth. However, this is not equivalent to expecting taxpayers to bail out insolvent companies by nationalising their distressed debt. The market economy is built on the principle that unviable businesses should be allowed to fail, so that promising new ones can prosper.
Debt and capital markets must never shift risks from business operators to small investors who lack the understanding of managing risk. No amount of well-crafted legal documents should protect the interests of entrepreneurs at the cost of exposing small investors to avoidable risk.
Market regulation must be strengthened to prevent small investors from being short-changed by being sold high-risk products.
The eurozone economy has sufficient depth and breadth to offer institutional and individual investors a range of investment products that cater to the risk tolerance of nearly every investor. Small investors will frequently benefit by considering all eurozone investment options that offer clear risk information on capital market products to minimise the risk of wealth destruction.
We need business-friendly capital markets that are, however, equally committed to embracing the duty of care that regulators, stockbrokers and the business community have to small investors.
Trust is everything in financial markets. Once it is lost, it won’t be easy to restore.
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