From price caps imposed on energy firms to restrictions on the advertising of junk food, government intervention and tighter regulation have come to affect every industry. Over the past few years, however, this trend has been particularly prominent in the financials sector.
Greater regulation and intervention can help to promote fairness and competition, to raise standards, or to ensure safety; however, they can also place a considerable burden on businesses and institutions. Common criticisms include the problems created by higher costs and more onerous administrative responsibilities, alongside the risk of lower productivity and profitability – and, in some cases, the threat of personal liability.
Nevertheless, while greater regulation is not always welcome, it is often good news for investors in subordinated debt.
Subordinated debt ranks below the top tier of “senior” debt in the event of a company’s liquidation but offers a higher interest rate to compensate for the perceived higher level of risk. In fact, subordinated debt has many attractions: parent companies tend to be large, well-capitalised and highly rated, and actual rates of default have proved negligible. On top of this, more demanding regulatory requirements help to provide investors with additional peace of mind.
So why has intervention continued to increase, and how can investors take advantage of this long-term trend?
From laissez-faire to state intervention
In the latter part of the 20th century, governments set the monetary and legal framework, but allowed market forces to set prices and drive competition. Since the turn of the century however, we have started to return to a more interventionist approach, exacerbated by:
The Global Financial Crisis
The Covid-19 pandemic
1 – The Global Financial Crisis (GFC)
Corporate scandals – from Enron and WorldCom in the early noughties to the collapse of Lehman Brothers in 2008 – generated calls for greater oversight and improved regulation. The shock of the GFC threw a harsh spotlight on practices within the global banking sector, triggering wholesale changes to the operation of the financial system, and the role of central banks.
As major financial institutions teetered on the brink of collapse during the GFC, governments stepped in to prevent these “too-big-to-fail” companies from endangering the entire financial system. In the UK, this led to the nationalisation or part-nationalisation of a raft of banks and building societies, including Northern Rock, Bradford & Bingley, Lloyds Banking Group, and RBS (now NatWest Group), in which the government remains the majority shareholder.
Massive amounts of taxpayers’ cash were used to bail out the banks, sparking widespread criticism of the banking sector and resulting in sweeping regulatory changes, including the “Basel III” reforms which were introduced to control risks within the sector, to ensure that banks had sufficient capital to withstand severe financial shocks – and to shore up public confidence in the strength and credibility of the financial system.
2 – The Covid-19 pandemic
Mandatory home working, travel restrictions, social distancing, and the wearing of masks … the Covid-19 pandemic has helped to normalise state intervention in everyday life – and this includes extensive fiscal intervention. As widespread lockdowns forced many businesses to shut down, governments around the world responded by introducing support packages in the shape of business loans, tax breaks, furlough schemes, and direct cash payments to households. Shocked by the ruthless spread of the pandemic, the public was generally receptive to a temporary loss of everyday freedom and economic growth in favour of public health and short-term financial stability. Looking ahead, however, people are likely to call for a return to their previous liberty and a brighter economic future.
Meanwhile, shortages of key components forced governments to examine structural vulnerabilities in supply chains, and companies to review their business models. This has resulted in a move away from the globalised efficiency of a “just-in-time” approach and a renewed focus on onshore resilience.
3 – Rising populism
The GFC exacerbated existing economic inequalities, helping to drive an increase in populism that was intensified by the subsequent sovereign debt crisis in Europe. Although Covid-19 generated collaboration on a global scale, it has also accentuated economic and social inequalities. Different countries are likely to emerge from the pandemic at different rates and in varying states of economic repair. These disparities could exacerbate existing inequalities, creating a fertile environment for further growth in populist policies that are designed to gain support from ordinary people who feel “left behind”. In turn, populism can provoke greater levels of intervention, leading to protectionist strategies that restrict imports in order to protect domestic industries, disrupting the flows of trade and capital, and destabilising supply chains.
The chart below illustrates the rise in populist world leaders over the last three decades and the shifting ideologies that have driven them to power.
The changing role of central banks
The role of central banks continues to evolve. Since the GFC, central banks have taken unprecedented measures to support the financial system and have continued to expand their toolkits to address current and future risks.
The Prudential Regulation Authority (PRA) was set up after the GFC to supervise banks, insurance companies, and other financial institutions, and is part of the Bank of England. One of the PRA’s most high-profile recent interventions came when it put pressure on UK banks to suspend dividend payouts, share buybacks, and cash bonuses in order to shore up their capital positions as the Covid-19 pandemic took hold. Although dividend restrictions on banks were eased before the end of 2020, they were not lifted completely until July 2021.
“Bank-related legislation and accounting standards are highly developed, effective and transparent”
- Fitch Ratings, July 2021
The world’s leading central banks have harnessed unusual strategies to shore up economic growth. In many cases, measures such as quantitative easing – in which central banks purchase bonds in order to reduce the interest rates on savings and loans – were initially regarded as short-term strategies designed in response to exceptional circumstances – however, they have now become commonplace.
Elsewhere, the long-term implications of climate change are generating legal and regulatory changes that will continue to affect companies and individuals. Climate change is being tackled at both a national and an international level; this is likely to provide support for future global collaboration, and central banks are expected to play their part.
“It is incumbent on any governor of a central bank to recognise the crucial role the financial system can play in accelerating the sustainability goals of their country”
- Kyrylo Shevchenko, Governor, National Bank of Ukraine
Making the most of a megatrend
The rise of state intervention and greater regulation is a long-term trend, born out of the laissez-faire capitalism of the late 20th century, forged in the fire of the GFC and the sovereign debt crisis, and accelerated by the Covid-19 pandemic.
Although it is a trend that can be controversial, intervention has come to affect almost every area of public and corporate life. Dramatic increases in regulation over the past decade have not always been universally applauded; nevertheless, in many cases they have resulted in stronger companies and greater security for investors – and this is good news for investors in subordinated debt.