Annual ICMA-NCMF Joint Seminar:
THE WAVE OF REGULATORY REFORM AND ITS IMPACT ON CAPITAL MARKETS –
Anne Merethe Bellamy, Finanstilsynet
Like other countries in Europe, Norway faces major challenges posed by the wave of new regulation in the securities market. In the years ahead substantial change will be seen in areas covered by virtually all key directives. I can mention MiFiD, MAD/MAR and the Transparency Directive. This is in addition to the recently adopted AIFMD and EMIR- Major changes are a particular challenge to the capacity of the smaller securities supervisors in Europe. Being an EEA country, Norway faces an additional challenge since EU regulations, which apply directly elsewhere in Europe, have to be incorporated in the EEA agreement and transposed into Norwegian legislation.
A new challenge for the Norwegian supervisor is the nature of its relationship to the European supervisory authorities ESMA, EBA and EIOPA. Our relationship to the new authorities is unclear since the regulations establishing them have yet to be incorporated in the EEA agreement. A difficult question in negotiations with the EU is how far the above agencies should be able to adopt binding decisions on authorities and individual institutions in the EEA countries. The Norwegian constitution imposes constraints in this respect. Finanstilsynet currently attends ESMA's meetings, as well as in EBA and EIOPA, in an observer capacity and participates largely in line with EU countries – of course without the right to vote.
ESMA's stakeholder group recently presented a report on small and mid-size entities'' ability to operate under the new regulatory regime and to attract the necessary capital. The report's conclusion, not surprisingly, was that the enormous growth in regulation is seen as a major problem for small and mid-size entities. The group recommended to relax the rules in virtually all key areas. It also recommended adopting a definition of SMEs that would entail categorising the great majority of listed companies on the Oslo Stock Exchange as SMEs. A concern shared across all Europe is that massive regulatory requirements could impede the growth of new activity. At the same time, the most important consideration behind the requirements is to ensure investors protection and good information. It is a paradox that rule relaxations should be recommended in areas where the risk is likely to be greatest, namely among small firms. This is a very difficult issue.
Structural changes in the stock market
Recent years' regulatory and technological developments have brought major structural changes in the securities market. Entirely new trading patterns have emerged in the secondary equity market. Internet broking and various forms of algorithm-based trading have increasingly replaced traditional stockbroking. The need for traditional brokers is reduced, and revenues in the form of brokerage and spread are significantly reduced. Another trend is that larger investors gain direct market access through investment firms – a form of self-service.
The most liquid Norwegian shares are traded on several marketplaces in addition to the Oslo stock exchange. Larger investment firms therefore invest in smart order routing systems. These enable automatically entered orders to be directed to the marketplace which currently has the best price for share concerned. Larger investors expect such services to be offered, which requires investment firms to invest in new systems. Concurrently price competition increases among brokers, and profit margins fall.
This has brought a sharp reduction in investment firms' stockbroking revenues. Investment firms' revenues from stockbroking fell by 40 per cent (NOK 452 million) from 2011 to 2012. From 2007 to 2012 the decline was 77 per cent (NOK 2,280 million).
Investment firms' revenues from corporate finance business are heavily dependent on the equity and bond markets. In a market coloured by investor uncertainty and/or falling stock values, a large proportion of companies planning to apply for listing or to issue stock will postpone or cancel such plans because prices and other terms are poorer than in a bull market. Nevertheless, iInvestment firms' revenues from stock issues have risen substantially – for investment firms integrated in banks in particular. This refers to the bond market, to which I will return-
For many investment firms - smaller and not integrated in banks, the shortfall in earnings from their traditional core business has led to negative profit. As a consequence, some mergers and acquisitions have taken place, and some businesses have closed down. Moreover, some firms whose main revenue sources used to be stockbroking and corporate finance, have taken up business in asset management and investment advisory services.
The new market conditions could lead to consolidation and business closures on a larger scale than we have seen so far.
The bond market
In the last few years we have seen a substantial rise in activity in the bond market, in Norway as elsewhere. Bond issues in the primary market (new issues and taps) quoted on the Oslo Stock Exchange and Oslo ABM rose from NOK 146 billion in 2007 to NOK 309 billion in 2012. In the same period the turnover of bonds (excluding repos) in the secondary market quoted on the Oslo Stock Exchange and Oslo ABM rose from NOK 481 to 692 billion. Non-financial companies funding in the bond market has increased with 20% since last summer. If this trend continues, the financing structure of non-financials may change. Traditionally about 10% of their funding is issuance of bonds.
Market participant’s interest in high yield bonds has grown. The reason lies in changed conditions on both the demand and supply side of the bond market.
The main contributor on the demand side is several years of very low interest rates, prompting investors to search for higher yield than that available on bank deposits, various fixed-income funds and low risk bonds. Investors are accordingly opting for higher risk investments including high yield bonds. On the supply side too, historically low interest rates and expectations of continued economic growth, explain parts of the increase in issuance of bonds. It is also asserted that as a result of the switch to tighter credit practice among banks, a number of companies that previously would have obtained their funding from a bank, no longer have this option and instead turn directly to the bond market for their funding. This is probably only partially correct.
Funding in the bond market is both a supplement to and substitute for borrowing from banks. This is positive from a systemic perspective.
Companies with a good investment grade are reported to have raised bank loans on very good terms, while firms with a poor investment grade and/or operating in segments deemed to be risky, have either obtained a loan at very high interest or been refused a loan altogether. Companies with a poor investment grade are therefore far more dependent on funding by means of bond issues in the market. At the same time many companies also consider it desirable to diversify their portfolio of external capital.
Despite the increase in issuance of corporate bonds, banks are still the main funding source for corporates in Norway. Approximately 70% of the funding of businesses in Norway is bank borrowings.
Even though the reduction in risk weights for home mortgage loans in the capital adequacy regime, exceeds the reduction in risk weights for corporate borrowings, there is no obvious correlation between the relative risk weighting and banks' pricing of loans. Moreover, banks themselves have since the onset of the financial crisis in 2008 had to pay relatively heavily for their own funding in the bond market (senior bonds). Some say this may explain the reduction in bank lending to corporates. In the second half of 2012, however, risk premiums on banks' senior bonds fell by a relatively wide margin, without leading to any increase in bank lending to corporates
Time will show whether recent years' increased activity in the bond market marks a lasting change, and whether the bond market has become an alternative to banks as a source of finance for Norwegian medium sized businesses and industry ahead. What is certain is that in the past few years the Norwegian bond market has functioned as an important funding source for corporates as a supplement to bank loans.
An issue is whether the lasting low interest rates and investors' search for yield could lead to overinvestment in high yield bonds, with potential severe losses for investors and risk for financial instability.
Another issue is whether investors who purchase high yield bonds understand the risk of investing in such instruments. High yield bonds have a number of characteristics suggesting similarities with bonds carrying low risk (investment grade) and to some extent with shares. An investor in high yield bonds runs a genuine risk of receiving neither the stipulated periodic coupon interest nor the principal when the bond matures. The investor is compensated for this risk by the promise of a relatively high coupon rate.
Trading in bonds in Norway takes place primarily between institutional and professional parties. So far there has been little need for any form of intervention in the interest of consumer protection or the like. Even so, there may be a case for strengthening market transparency by permitting access to the bondholder register and more disclosure of trade information, in light of the increased volume in corporate bonds
Interest rates are low, and many would like to see higher rates of return than those available on bank deposits. At the same time, banks and investment firms are seeking to compensate for loss of earnings on traditional stockbroking by earnings from other sources. There is a danger that sales of complex products carrying high risk could increase for this reason. In light of developments in the corporate bond market, Finanstilsynet also sees a risk of consumers being offered high yield bonds without being given satisfactory information on the risk involved. As part of its mandate on consumer protection, Finanstilsynet overlooks, and will continue to overlook, the bond market.
Consumer and investor protection is at centre stage of the statutory regulation of the securities market. It is extremely important that consumers should be well protected when buying and selling financial products, and that they can base their decisions on good information and impartial advice. The international financial crisis underscored the need for consumer protection. Loan bubbles and banking crises have inflicted heavy losses on a number of countries and their populations. We have also seen, in Norway as elsewhere, many private individuals suffer losses on investments in complicated financial products after receiving poor investment advice and inadequate information on products' costs, risk and possible rate of return – or absence thereof. The consequences of differing investment choices may be unclear and of substantial financial significance for the individual consumer.
Finanstilsynet has brought to light several instances of gross, systematic breaches of good business practices in their dealings with customers. Finanstilsynet will continue to keep a close watch on investment advice provided under the auspices of investment firms and banks and will apply the necessary sanctions in the event of serious violations of customer protection requirements.
Good, effective market supervision is a further area of continuous focus for Finanstilsynet. Safe, secure and efficient trading is a precondition for the securities market to function as a source of capital for business and industry and as a basis for investment and saving. Recent years' fragmentation of the European securities markets has resulted in new market platforms (multilateral trading facilities) taking much trading volume away from the traditional stock exchanges. The fragmentation of securities trading, leaving no single marketplace with an overall view of the market, poses a major challenge to the effort to identify market abuse. Squeezed operating margins at the traditional stock exchanges mean that market surveillance is not given the same priority as previously. Finanstilsynet will consider whether market surveillance is good enough for the future.
Anne Merethe Bellamy, 19. Mars 2013.