Market-Based Finance System Moves In as Banks Buckle

Terry Flanagan

With the ratcheting up of capital requirements for banks, market participants believe that there is likely to be a greater dependency on market-based financing to fill the void left by banks in the future.

It has been debated for many years whether a bank-based or market-based finance system is better. Banks, though, are having to gear up to deal with a plethora of post-crisis regulations, such as the Basel III capital adequacy regime, and fear many years of misery ahead.

“The future of market-based financing is set to increase dramatically,” David Wright, general-secretary of Iosco, the umbrella group of global securities regulators, told delegates at last week’s World Exchange Congress in London.

“The Basel agreement ratchets up capital for the banking system by five times or more. Capital levels in the banking system are going up and are going to go up dramatically. I don’t see any evidence at all that those capital levels will come down in the future; if anything they may go up more. So that means the provision of credit in the economy is going to be relatively constrained.

“And there are other factors. If you look at the international discussions on managing requirements for OTC derivatives, margin for clearing houses or haircuts for repos, then you are going to see more capital tied up for collateral provision.

“Some people worry about this so-called collateral crunch. All of this will constrain credit provision and require market-based financing to fill this increasing financing gap at the global and local level.”

Many capital market institutions are seeing this as a real potential growth driver, especially in the current low volume environment where profits are harder to come by.

“This is a systematic opportunity,” said Gerard Mizrahi, managing partner and chief executive of Charles Street Securities Europe, a U.K.-based private equity and venture capital firm.

“It is resulting mainly from the withdrawal of banks from the banking system. There are a lot of credit-related opportunities that previously would have been done by the banks that are now being done by various private lenders and hedge funds and all sorts of new intermediation that has been created.”

Exchanges, too, who suffered a dismal 2012, are also eyeing their slice of the pie. In a market-based finance system, the majority of financial power is held by the stock market and the economic mood of an area is dependent on how well or poorly the stock market is doing. Whereas under a bank-based system, the economy is more dependent on how well the banking industry is faring with wealth spread more evenly.

“There will be tremendous opportunities going forward for trading for equity markets and for all exchanges—bonds, commodities, derivatives you name it,” said Wright at Iosco.

“Market-based finance is going to have to play a much bigger role in financing the global economy in the years ahead.”

But the capital markets are being warned that they will have to up their game in order to cope with this new elevated role.

“Access to efficient capital markets continues to assume ever greater importance as companies shift away from bank financing towards a greater reliance on capital market funding,” said Martin Scheck, chief executive of the International Capital Market Association, a trade body.

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