The impact of the new regulatory paradigm on the role of banks in financing the economy

The financial crisis exposed the weaknesses and excesses of the banking system, notably its growing reliance on short-term market financing, excessive levels of leverage, and the fact that many banks were conducting high-risk market activities alongside retail banking activities. In 2009, in reaction to the crisis, regulatory authorities embarked on an ambitious agenda of reforms to financial regulations, aimed at cleaning up and reinforcing the banking system and ensuring it can meet the credit needs of the economy and sustain growth. Although these reforms are largely aimed at the banking sector, some of the changes also address disfunctions in capital markets and in other forms of financial intermediation (shadow banking). In response to this new regulatory paradigm, banks have already begun to adapt their business models. By encouraging better risk selection and management, the regulations aim to ensure banks serve the needs of the real economy. However, in continental Europe, where financial intermediation is predominantly bank-based, stricter refinancing and solvency requirements could lead to a decline in bank lending to small and medium-sized enterprises, creating an unwanted fragmentation between businesses according to size. In parallel, the growing importance of capital markets and non-bank financial institutions is prompting banks to redefine their role in the financial system. Financial disintermediation, and the replacement of banks with non-bank funding, still relies on the participation of the banking sector; the latter guarantees market liquidity and provides origination for many financing projects. Consequently, financial regulation and public initiatives should also ensure that banks continue to play a major role in financing the European economy and in accompanying the transition towards broader financial markets.