Is Europe Losing Its Competitive Edge? Regulation, Growth and Finance with Jonas Bjarke Jensen #5

As Europe faces growing competition from other global economies, questions around productivity, growth and financial regulation are becoming increasingly important. In this episode of Mortgages Covered, Jonas Bjarke Jensen of Copenhagen Economics shares his views on how regulation can support — or hinder — competitiveness, investment and long-term economic growth.

This Episode of Mortgages Covered explores:

• The factors driving the transition to a new global economic and financial environment and the resulting policy implications.
• Europe's widening productivity gap relative to other major economies and its implications for financial regulation.
• The impact of existing EU regulation on competitiveness and market efficiency.
• Market distortions, including the effects of the Basel output floor on bank's lending rates.
• The short-term and long-term solutions 

Transcript

SPEAKER_00 0:00

Article four six five of the capital requirements regulations sounds like a pretty arcane and nerdy detail, but actually it's absolutely vital to the ability of banks to advance mortgages, the price of that mortgage, and the stability of the whole sector. Johannes Jensen of Copenhagen Economics explains why.

SPEAKER_01 0:33

So um I'll be discussing potential regulation and competitiveness and simplification, how these words are related. So I'll start this presentation with a claim that it is possible to uh reform, to simplify potential regulation in a way that contributes to the competitiveness of the European economies without compromising financial stability. So that's my hot take here from the beginning, and then you can let me know at the end of the presentation if you uh agree with me. So I'd like to start this presentation by taking you all back to 2021. You remember it? It's it feels like a long time ago, right? A lot has happened since then. So in that time it was a slightly different global environment that we lived in. I would say back then we lived in a rule-based, efficiency-driven global environment where European countries was part of a global division of labor within economies that allowed sort of each European country to specialize to a high degree because you could rely on global supply chains. That has somewhat uh changed with um the development the past uh five years. And it was in this uh previous global environment that the European Commission announced uh their suggestion or a proposal for implementation of final Basel III, it was actually in in October 2021. Um yeah, and since then uh a lot has uh happened. Um so particularly 2022 really marked a year of change and a transition to a new uh new global uh environment. So Russia invaded uh Ukraine uh that of course completely destabilized uh the geopolitical situation in Europe but also globally. Uh there was an energy crisis that kicked in in 2022, then it does sort of a new high inflationary regime. And then there was the US Inflation Reduction Act. Uh there was an act or a package in in the US that hasn't that much to do with reducing inflation. It was sort of a first wave of you can say a more protectionistic uh policy or economic policy package, where to a large extent there was a subsidy of um domestic production. So we started to see sort of a more protectionistic uh global environment uh already in 22. And then finally, this guy came along, uh ChatGPT opened up in 2022, which of course also has the potential to reshape economic structures and made it abundantly clear that we are very depending on on US tech. So already in 22 uh we could see sort of a beginning of a new global environment. And that just just took pace in or accelerated in 25. You all know the story. Trump got inaugurated, announced massive terrors on allies, everybody including close allies, and effectively ended uh this very close EU-US collaboration or alliance that we have. That means we are now in a more sort of fragmented uh world. So it has become moved from maybe being important that the the European economies are uh productive and enhanced productivity was an important issue before, but now it starts into become sort of more existential. We the fact that we are losing pace to US and to other global peers uh is increasingly an issue in this more fragmented world. Um so you can say the fact that there is a gap on productivity that's not necessarily something new. Uh that has been there since uh 2000. So here we have productivity for US and for EU, but the gap is widening. So back in uh 2005 it was 12%, and now it is a uh 19%. And with the introduction of AI, there is maybe scope for this gap further to widening. Um so there is a clear, you can say, yeah, call for action or burning platform that um we need to be able to improve the productivity of uh the European economies. Now, what has that implication for financial regulation? So fundamentally, does that change uh the fundamentals or the principles around how good financial regulation looks like? I would say no, not necessarily. The same principles that was back 10 years ago would still apply today. So, in that sense, it doesn't fundamentally change the principles, however, it does change the urgency of how we need to support growth and scaling of new sectors and new technologies. So it's the urgency here which is the new uh thing. So you can say before that Euros was part of a global economic division of labor, it was not necessarily a major issue uh issue that technological projects took place outside of Europe because we could use that technology, and it was not an issue that the EU uh relied on on global supply chains, and the fact that we were falling behind on productivity was maybe not the same way existential. Now it is indeed very much an issue. We need to be able to scale new technologies, new sectors, new supply chains, and also to enhance the economy-wide productivity, and there we really need efficient capital markets. So this is why that simplification and competitiveness have moved to the to the top of the agenda. So, um, how is the current EU financial regulation then a barrier to uh competitiveness? Um part of the issue is exactly this very complex financial regulation that we have built up over the years. So you can say the current regulation to some extent reflects layers of different kinds of compromises over the years that have resulted in a system that has these, to some extent, counterintuitive and also to some extent economically inefficient uh effects. So, an example of that, and you probably you you also can see it in your work and have other examples of this, but one example is for example, how many times is the risk of a crisis addressed in the capital requirement framework? So I sit and did a brainstorm with myself, and on top of mine I counted six different times that the risk of economic crisis was accounted for. So, first you have the risk rate framework that is supposed to cover unexpected losses, right? So that's one. Then you have a stress test buffer, so you stress that framework that's also supposed to account or simulate economic crisis. Then in this stress test, you use stressed LKDs as input to the risk rates. So you sort of have triple counting all the way there. On top of that, you have pillar two requirements that often are stress-related, so additional capital buffers, there are some countercyclical buffers, and then finally we have an output force and leverage ratio that also are supposed to be a backstop uh to ensure that the banks are sufficiently capitalized for economic crisis, right? So this was six times I counted. Um maybe you have a few more examples, uh, then uh then let me know. And the problem is that it becomes very difficult to find out is this actually the optimal level when you have that many layers. So, what does all this add up to? Um, maybe for some banks, this is the optimal capital, this is uh perfect, but it's very difficult to find out. Uh, at least personally, I have lost the overview of it. This is actually an optimal level, and I think also in general, yeah, it's difficult really to uh to assess. So that's one um difficulties with the with this very complex revelation where we need simplification. We need to be able to assess what is actually the optimal level of capitalization that strikes the balance between competitiveness and uh prudential uh considerations. Another element where I think there is scope for simplification and looking at competitiveness is uh in particular looking at uh the output force that are implemented. Um, this is an impact study we did back in 2022, I believe it was, for European um market federation, where we look at how is this going to um the output force, how is that going to impact different um different sectors. Um and we could see that where there was actually the biggest impact that was on the corporate mortgage portfolio. There was an increase in capital requirement for that for on um 44%, higher than uh SME lending and also higher than household mortgages. And that's an issue because this is exactly what Ruggi calls productive investments. So corporate investments is what builds on the capital stock and what eventually contributes to productivity. So if you want to enhance productivity, increasing capital requirements there for the corporate market portfolio that much are going to have an impact on uh productive investments and therefore also competitiveness. So that's one element. There are also some in this complex regulation uh some some uh counter-tuitive effects that different banks are being impacted differently. So some banks are being impacted by the output flaw, but others are not, and that gives some a bit peculiar effects in the market. For example, we have analyzed it, you have some markets where some banks are being bound, some banks are not being bound. That means that you, for example, in a case, let's make a simplified case, you have two identical companies. They're exactly the same. One is in bank A, which is bound by the output flow, and the other one is a bank B, which is not bound by the output floor. Then we estimated with this increase in capital requirements, how is that going to impact the lending rates? And for these two exactly the same companies, the one company in in bank A had an increase in in lending rates of around 30 to 40 basis points, and the other one didn't have any increase. These distortions in markets that has some some uh negative effects on um on um productivity because it it these increase in lending rates rather in it diminishes uh investments, so of course reduce incentives for for invest for this uh company in in bank A and can therefore spill over to an impact on productivity. In such a case, might be that the the company in bank A will move to to Bank B to get uh cheaper cheaper funding, but it gives some distortions in in the market that can be um that can be an issue. So when we look more globally in this more fragmented global environment that we are looking into, um it's also worth noting that other jurisdictions they interpret uh final parcel free a little bit differently. Uh so you can say in in US right now uh the approach is being recalibrated and they have sort of a more, let's say, flexible approach to how to interpret um the capital uh requirements. Uh so in that sense, we don't have sort of a uniform global uh implementation at the moment. And it's also worth noting that even the same regulation was always going to hit uh differently in different jurisdictions. So if you look at how uh European corporates are funding themselves with uh debt funding, you can see here that around 85% is based on bank financing and 15% on capital markets when it comes to debt, and in US it's more balanced, it's more 50-50, right? So even the same increase in capital requirements for banks were gonna impact productivity differently in US and in um and in EU. So, what what to do about it? I think there are maybe two uh two approaches to this: a short-term approach and then a more uh long-term approach. So, short-term, I think it's about there are about to be implemented some capital requirements that's going to have some some uh these counterintuitive effects, and I think it's about making sure that these aren't being implemented because that's going to harm productivity and competitiveness right here, right now. So there is maybe one approach could be to say now we we stop or we halt the implementation in the short term uh and see how it plays out on the sort of global political uh scene. So that's maybe one element, but I think more that doesn't solve the that maybe solve the problem of these counterintuitive effects, but it doesn't solve the problem of an overall complex regulation, right? So I think in the more long run, we need to think how can we sort of overall simplify the capital uh requirements framework. Maybe just have one stack, one stack approach to say this is the capital requirements for uh for banks that being calibrated for each bank, and in this to make sure that there is this right trade-off between potential considerations and um competitiveness. And in doing so, it is important to take all the good research that there is on this topic because that has actually been researched a lot. What is the right balance between capital requirements and um and growth? So this is uh uh some calculation actually the Basili Committee out here on the the left-hand side, Basel Committee did um uh back in 2010, where they sort of assess what is the risk of an economic crisis given a level of capital requirements, where they see that is of course declining, higher capital requirements, lower risk. So that's sort of one side of the coin. And the other side of the coin, there is a bunch of research on how uh what is the impact on GDP when you increase capital requirements, uh both uh old literature but also newer estimates. So there you sort of have two sides, two elements of this, and this is important in in designing financial regulation and finding that maybe one simple approach to what is the right level of capital requirements, to combine these two into some kind of assessment. What is uh the optimal capital to bring that trade-off back? You can uh increase capital requirements too much, make it too complex, too many, then you will um have declining return, but you can also um yes, you need to find that balance between these two sides and have that in um potential regulation that I think is going to be important in this ongoing discussion around uh simplification, uh competitiveness, and of course still safeguarding uh prudential considerations. Thank you very much.