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The emerging regulatory landscape: a new normal

Breaking the link between banks and sovereigns


The study provides an insight on the regulatory requirements that banks have been complying with since the financial crisis of 2009. Precisely, it focuses upon the Bank Recovery and Resolution Directive’s full implementation and effectiveness. An empirical analysis on the European banks’ CDS market sheds light on the mechanisms driving its current and historical developments, emphasizing the motivations for the change in the regulatory architecture. The policies will be proved to be effective in changing investors’ risk perception, that is, a shift of risk burden from senior bondholders towards subordinated debt holders, as well as a breakdown of the link between banks and sovereigns’ default probabilities, the so-called doom loop. Ultimately, a comparative analysis on banks’ capital requirements, return on equity, leverage and risk weighted assets provides evidence on the impact regulations have on the European banks’ business strategies, thereby shaping the New Normal. In conclusion, the paper discusses whether the current regulatory regime will be able to prevent future sources of instability.

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Figure 1
Figure 2
Figure 3

Source: Bloomberg.

Figure 4

Source: Bloomberg.

Figure 5

Source: Bloomberg.

Figure 6

Source: Bloomberg, Own Calculations.

Figure 7

Note: The size of the bubbles represents the Return on Equity of the Banks.

References and Notes

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  5. 5.

    Ibid., p. 10.4 These bills of exchange allowed merchants to trade abroad without the need of having the money pragmatically. This has been a revolution in terms of risk-protection and market access. As Felloni emphasizes “The limits fixed by the Church may have helped to contain certain explicit forms of money lending with interest, but they were not able to prevent other modified or disguised variations developed to dodge the accusation of usury”.

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    See p. 11, Felloni, G. (2005) Genoa and the history of finance: a series of first?. Banco di San Giorgio, Genova.

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    Basel III has been converted into a EU legislative package by the Capital Requirement Directive (CRD IV), which aims at enhancing quality and quantity of capital, the basis for new liquidity and leverage requirements, and creating new rules for counterparty risk, and new macroprudential standards. It will be fully loaded within 2019.

  13. 13.

    The Financial Stability Board (FSB) has issued on November 9th 2015 a set of principles and a detailed term sheet on the adequacy of loss-absorbing and recapitalisation capacity of global systemically important banks (G-SIBs) in response to the request of G20 leaders (2013 St. Petersburg Summit) to enhance loss-absorbing capacity of G-SIBs in resolution. For further details, see Financial Stability Board. (2015) Principles on loss-absorbing and recapitalisation capacity of G-SIBs in resolution. Total loss-absorbing capacity term sheet, 9th November 2015.

  14. 14.

    To avoid institutions structuring their liabilities in a way that hampers the effectiveness of bail-in or other resolution tools, the BRRD requires institutions to meet a robust minimum requirement for own funds and eligible liabilities (MREL). This is not a fixed figure imposed by legislation, but is to be set on a case-by-case basis by resolution authorities. To ensure consistency, the BRRD lays down common criteria for resolution authorities to apply and these technical standards further specify these minimum criteria.  For further details, see European Parliament. (2014) Directive 2014/59/EU of The European Parliament and of The Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms. Official Journal of the European Union, 15th May 2014.

  15. 15.

    See p. 50, BBVA Research. (2014) Compendium on bank resolution regimes: from the FSB to the EU and US frameworks. Regulation Outlook, June 2014.

  16. 16.

    For further details see Financial Stability Board Key Attributes 2011/2014; Financial Stability Board. (2011) Key attributes of effective resolution regimes for financial institutions. October 2011.; Financial Stability Board. (2014) Key attributes of effective resolution regimes for financial institutions. Oct. 2014.

  17. 17.

    See Financial Stability Board, p. 4.13

  18. 18.

    Ibid., p. 10. Nevertheless, as from January 2022 it will increase respectively to 18 per cent of RWAs and to 6.75 per cent of the Basel III leverage ratio denominator. This requirement does not include any applicable regulatory capital buffers (Basel III), which must be met in addition to the TLAC RWA Minimum. Moreover this requirement does not limit authorities’ powers to set a threshold above the common minimum or to put in place buffers in addition to the TLAC LRE Minimum.

  19. 19.

    Still the threshold is under calibration since according to the Bank of England the optimal bank capital for a bank should be around 20 per cent of RWA. The calibration is a fundamental step of the approach since a disproportion of treatment between RWAs and Leverage threshold may harm one specific business model, respectively commercial and investment bank if the RWAs and leverage constraints are set too high. See Miles, D. et al (2011) Optimal bank capital. Discussion Paper N. 31, Bank of England

  20. 20.

    The indicators used to assess the systemic importance of the bank are equally weighted and consists in the following ones: size, cross-jurisdictional activity, interconnectedness, substitutability/financial institution infrastructure and complexity. See p. 4, Bank for International Settlements. (2011) Global systemically important banks: assessment methodology and the additional loss absorbency requirement. November 2011.

  21. 21.

    See BBVA Research, p. 1.15

  22. 22.

    For further details, see principle 11 “priority”, p. 15.17

  23. 23.

    It is important to underline that if the minimum TLAC is set too high, two negative externalities could harm economic growth: (1) enough instruments may not be available in the market or an insufficient demand may trigger a deleveraging process thus reducing outstanding credit to corporates and households. (2) In order to maintain profitability in line with corporate’s goal, banks may seek risky investments to offset TLAC costs. On the other hand a too low TLAC threshold may let the bail-in tool be ineffective, thus leaving the ‘too big to fail’ issue unsolved in case of a financial crisis.

  24. 24.

    This is even more relevant in the case of the European Union, where banks lending counts for almost 80 per cent of total funding compare to less than 25 per cent of the US economy. Wehinger, G. (2012). Bank deleveraging, the move from bank to market-based financing, and sme financing. Technical Report 2012/1, OECD Journal: Financial Market Trends.

  25. 25.

    See p. 13, BBVA Research. (2014) Compendium on bank resolution regimes: from the FSB to the EU and US frameworks. Regulation Outlook, June 2014.

  26. 26.

    The minimum threshold should be larger than the following ratio: owns funds plus eligible liabilities with residual maturity >1 year divided by total liabilities and own funds considering netting rights in derivative contracts. “Resolution authorities are therefore required to assess whether the level of MREL is sufficient to ensure that the conditions for use of the resolution fund described in Article 44 of the BRRD could be met. That article requires that a contribution to loss absorption and recapitalisation of not less than 8 per cent of the total liabilities including own funds of the institution (or, under certain conditions, 20 per cent of RWAs) has been made by the holders of relevant capital instruments and other eligible liabilities”. See p. 12, European Banking Association. (2015) EBA Final Draft Regulatory Technical Standards. On Criteria for Determining the Minimum Requirement for Own Funds and Eligible Liabilities Under Directive2014/59/EU. Regulatory technical standards,3rd July 2015.

  27. 27.

    The resolution fund will be funded by all financial institutions proportionally to their total liabilities and risk profile. By December 2014 the resolution fund must have reached at least 1 per cent of the amount of all covered deposits. See p. 27.25

  28. 28.

    The EBA is additionally required to submit a report to the Commission by 31 October 2016 reviewing the implementation of an MREL at national level and several aspects of the framework for an MREL set out in the BRRD. See p. 6.26

  29. 29.

    The supervisors will assess and approve recovery plans annually. See, p. 16.26

  30. 30.

    See Financial Stability Board, p. 7.13

  31. 31.

    The European approach is more discretionary since breaching the MREL can be due to market systemic problems or to excess perceived vulnerabilities and not by the worsening of the financial position of the bank. See BBVA Research. (2015) MREL and TLAC: What are the consequences of breaching them?, Europe Regulation Outlook, 8th Jan. 2015.

  32. 32.

    See p. 10, Scope Ratings. (2014) European banks through new eyes: an outlook for 2015 and beyond. 2nd December 2014. SCOPE: OUTLOOK 2015

  33. 33.

    The cumulative shortfalls are respectively EUR 423.9 bn and EUR 223.2 bn. For further investigation, see European Commission. (2013) Bail-in tool: a comparative analysis of the institutions’ approaches. Working paper European Commission, 18th October 2013.

  34. 34.

    See International Financial Law Review, March 2015;

  35. 35.

    See p. 4, Scope Ratings. (2014) AT1 capital instruments background and key risks for investors. 10th June 2014

  36. 36.

    AdT1 securities can cover 18.75 per cent of the 8 per cent capital requirement, while T2 securities up to 25 per cent.

  37. 37.

    See Scope Ratings, p. 21.32

  38. 38.

    It is important to underline that secured debt such as covered bonds and short-term debt with maturities of seven days or less are not subject to bail-in. Moreover senior unsecured can be issued through a holding company or in case through a parent operating company specifying in the debt contract the “bail-in clause”.

  39. 39.

    See p. 4, BNP Paribas. (2014) Credit Focus: The new financial CDS landscape. 2nd October 2014.

  40. 40.

    The announcement has led to “a decrease of about 200 basis points in the 2-year government bond rates in Italy and Spain, while leaving German and French bond yields for comparable maturities largely unaffected”. See Altavilla, C. et al. (2014) The financial and macroeconomic effects of OMT announcements. ECB Working Paper n. 1707

  41. 41.

    For further details on the topic and the effect of the Stress Test results on the European banking sector performance see also Ambrosini, G. and Covi, G. (2016) Stressing Bank’s Asset Variance: The Impact of the 2014 Comprehensive Assessment on the CDS-Stock Relationship. Verona, IT: Department of Economics, University of Verona; Milan, IT: Department of Economics, Management and Quantitative Methods, University of Milan (Mimeo). DOI: 295075413.

  42. 42.

    Despite none OMT programmes were ready to start in September/October, the financial markets straight away took notice of the additionally planned OMT packages from ECB, and started slowly to price-in a decline of both short-term and long-term interest rates in all European countries previously suffering from stressed and elevated interest levels (as OMTs were regarded as an extra potential back-stop to counter the frozen liquidity and highly stressed rates; and just the knowledge about their potential existence in the very near future helped to calm the markets).

  43. 43.

    See Table A2 in the appendix and for further details on the regulatory requirements see also Bank for International Settlements. (2010) Basel III: a global regulatory framework for more resilient banks and banking systems. December 2010.; Bank for International Settlements. (2013) Basel III: liquidity coverage ratio and liquidity risk monitoring tools, January 2013.

  44. 44.

    For a detailed overview of this topic see Tirole, J. and Farhi, E. (2014) Deadly embrace: sovereign and financial balance sheets doom loops. Working Paper 164191, Harvard University OpenScholar.

  45. 45.

    See European Banking Association, p. 5.26

  46. 46.

    See p. 15.32 It is important to be aware that banks’ internal models may stretch the data in order to depict higher capital ratios and lower Risk Weighted Assets amounts.

  47. 47.

    See p. 8, Krishnamurthy, A. and Vissing-Jorgensen, A. (2011) The effects of quantitative easing on interest rates: channels and implications for policy. NBER Working Paper 17555.

  48. 48.

    For further details on this topic see also Fratzscher, M., Lo Duca, M., and Straub, R. (2014) ECB unconventional monetary policy actions: market impact, international spillovers and transmission channels. IMF 15th Jacques Polak Annual Research Conference; November 2014, Washington DC.

  49. 49.

    See p. 15, Haldane, A. G. and Alessandri, P. (2009) Banking on the State. N. 139/2009. Andrew Aldane does his analysis for the UK Banking Sector, nevertheless a similar pattern can be found for US and European Banks.

  50. 50.

    Similar results can be achieved with other metrics such as rate of return on risk-weighted assets – RoRWAs. In fact “European banks’ return on risk recovered from the 2009 financial crisis, peaking in 2010 with an average 1.3 per cent RoRWA. Since then, however, RoRWA has declined to 0.5 per cent on average. This translates to a level of profitability below the cost of capital, which means banks are destroying value”. See p. 7, Sinn, W. D’Acunto, R. and Oldrini A. (2013) European banking: striking the right balance between risk and return. Bane & Company Report

  51. 51.

    Risk taking is computed as RWAs over Total Assets, while Leverage is Total Assets over Tier 1.

  52. 52.

    See Haldane, A.G. et al, p. 5.49

  53. 53.

    Since the probability of default (PD) as well as loss given default (LGD) used to calculated RWAs through model provided by the Bank of International Settlement can not be always computable or objective, risky outcomes may lay under the surface. Moreover since ‘the black swan’ pops up suddenly and not gradually, and for its intrinsic nature cannot be forecasted, drastic recalibration may take place. This point rises the issue of pro-cyclical biases, a large capital base in period when it is unnecessary, while lack of buffers when it is most needed.

  54. 54.

    See Haldane, A.G. et al, p. 7.49

  55. 55.

    To investigate further the topic of limited liability see Grossman, R. (2001) Double liability and risk taking. Journal of Money, Credit and Banking 33(2): 143–159.

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Correspondence to Giovanni Covi.



Table A1 G-SIBs as of November 2015
Table A2 Basel III phase-in arrangements

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Covi, G. The emerging regulatory landscape: a new normal. J Bank Regul 18, 233–255 (2017).

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  • financial stability
  • systemically important institutions
  • financial crisis
  • banking regulation