Few institutions are able to implement strategic programmes for dealing with new regulatory and governance regimes and this has a greater negative impact on smaller organisations, says Anthony Gandy.

The sheer volume of regulatory change is causing some banks and insurers to creak under the weight of it, according to research from the Institute of Financial Services, Deloitte, HP and Oracle. The research, which was conducted among 62 major financial services groups worldwide and interviewing 105 senior management staff, shows that it is often the small and mid-tier institutions that suffer the most from regulatory change.

While the survey is positive about institutions’ ability to deliver regulatory change according to the timetable that governments and regulators set, there is still a significant burden, especially for smaller institutions. The reason is the inability of many companies to create a single regulatory co-ordination function and therefore their failure to build a strategic technology approach to dealing with the growing burden of regulation.

The research shows that 37% of mid-tier banking institutions, smaller retail banks and mortgage banks were finding it significantly difficult to keep up with regulatory change. This compares with 32% for larger banks and 24% for capital markets organisations and insurers.

Costs raise concerns

The problem that large banks face has been quite high profile in recent months. Reports from Barclays and HSBC have raised concerns about the cost of regulation. In its 2003 accounts, HSBC highlighted the $400m direct costs of complying with the hundreds of regulatory regimes that it faces around the world. In the ifs/Deloitte/HP/ Oracle research, one respondent said that, taking into account all the costs associated with compliance, the true cost for them was closer to £1bn.

Although the scale of regulation and the different regimes they have to deal with around the globe troubles these firms, it is the smaller firms that are struggling to cope. Regulation is increasing the cost of entry to the financial services sector so that, while the cost of regulation to smaller firms might be lower in absolute terms, they have to consider carefully in which sectors they want to operate so that they do not become overwhelmed.

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Heavy weight

It is not just financial services regulation that is affecting these firms. Corporate governance regulations and legislation, ranging from Sarbanes-Oxley in the US to The Combined Code in the UK, are aimed at producing governance structures that will protect customers and shareholders from poor practice and conflicts of interest. Large banks appear comfortable with the requirements of these legislative and voluntary codes of conduct: 89% of tier-one banks believed they had been successful at embedding corporate governance and best practice in their organisations. However, a quarter of smaller banking groups believed they had so far failed in this challenge.

Smaller banks face further problems with new anti-money laundering regulations. Designed to ensure that the financial services sector is not used for laundering criminal or terrorist funds, most countries have introduced a comprehensive know-your-customer programme. Confirming the source of funds and reconfirming the status of customers has become a burden to many institutions: 30% of survey respondents from Tier 2 banks believed that anti-money laundering rules and processes were reducing their competitiveness. When it comes to regulatory spending, Basel II is the most expensive programme in almost all banks but in the coming year to 18 months, anti-money laundering spending will also be high as new compliant processes are put in place.

Missing out on benefits

One of the most surprising survey findings is that many institutions cannot exploit the benefits that Basel II could generate for them because of the difficulty they face in building systems to cope with it. Small retail institutions should be able to benefit from reduced capital requirements following Basel II. However, only 45% of respondents for smaller banks believed that they would benefit from Basel II. A key problem was implementing the elite credit and operational risk measures.

A related finding is some banks’ belief that they will not see any real operational improvements following the implementation of all of these regulatory change programmes: 29% of smaller retail banks (Tier 2 institutions) and 31% of capital markets institutions expect to see no operational improvements following Basel II, Sarbanes-Oxley, the Patriots Act and the new international accounting standards (IAS).

Unexploited overlap

This inability to deliver systems that are able to exploit the potential benefits of Basel II is not the only systems-related problem that banks and insurers face. While there is a great deal of overlap between regulatory and governance changes, such as Basel II, International Financial Reporting Standards (IFRS) and Sarbanes-Oxley, many institutions are not able to exploit these commonalities. Sarbanes-Oxley overlaps with many of the operational risk components of Basel II as well as with many of the IFRS standards. IAS39, with its requirements for fair valuation of assets, overlaps with many of the requirements of Basel II. Above all, much of the data that institutions will require to report to these standards is similar in nature.

However, according to the survey results, only 26% of the risk and compliance bosses interviewed said that they had integrated programmes for dealing with Basel II, IAS 39 and Sarbanes-Oxley; 35% expected to run separate programmes and, worryingly, 39% did not know what they were planning. Among investment banks, 51% of respondents said that they would not have joint change programmes covering all these regulatory changes.

It is clear that many firms are not planning to build strategic regulatory report environments based on common data architectures. In the short term, this means that multiple projects have been initiated based on separate data collection, storage and analysis environments. In the long term, it means that institutions will lose flexibility for dealing with future regulatory changes.

This granular approach to running regulatory change programmes is a reflection of the difficulty that many institutions have had in creating a unified approach to regulatory change management. The survey found that 27% of tier one banks, 29% of tier two banks and 38% of investment banks have no centralised change management team for all regulatory change programmes. It is difficult to create a centralised strategic solution to regulatory change if there is no centralised management function in the first place.

The survey interviews showed that although some institutions are content to deal separately with each regulatory change, others recognise that it is not the right approach. One respondent noted: “Unfortunately, Basel II and IAS will be dealt with separately.” Another respondent had hopes that a more strategic approach would be taken in the future: “In the longer-term, it will be based on integrated reporting tools but initially it will be separate projects.”

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Timetable restrictions

Given the timetable restriction accorded to many of these regulatory change programmes, it is not surprising that many firms have taken the approach of adapting current systems and processes. However, what this does not face up to is the nature of regulatory change. Regulatory reporting is becoming more data intensive. It does not simply require data to be captured and a form to be completed. Basel II, IAS and even anti-money laundering regulations all require the data to be processed and analysed.

Data is no longer static; it is dynamic and needs to be used for analysis. Basel II data needs to be used for populating credit and operational risk models to calculate capital requirements. IAS39 data needs to be used for mark-to-market processes. Anti-money laundering data needs to be analysed by pattern recognition software to search automatically for unusual behaviour.

The research concludes that many institutions are facing ever-increasing costs of compliance as they fail to deliver strategic answers to the management and processing of the data required for new regulatory reporting requirements.

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